Trading Option Greeks E-Book

Dan Passarelli

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Bloomberg Professional
• Sprache: Englisch

Seitenzahl: 536

Veröffentlichungsjahr: 2010

Beschreibung

Veteran options trader Dan Passarelli explains a new methodology for option trading and valuation. With an introduction to option basics as well as chapters on all types of spreads, put-call parity and synthetic options, trading volatility and studying volatility charts, and advanced option trading, Trading Option Greeks holds pertinent new information on how more accurate pricing can drive profit. Most options traders focus on strategies such as covered calls, vertical spreads, butterflies and condors, and so on. But traders often don't know how to use the "greeks"--the five factors that influence an option's price--to trade more effectively. The "greeks" (Delta, Gamma, Theta, Vega, Rho) are tools to measure minute changes in an option's price based on corresponding changes in: * Interest rates * Time to expiration * Price changes in the underlying security * Volatility * Dividends Using the greeks can lead to more accurate pricing information that will alert an option trader to mispriced derivatives that can be exploited for profit. In straightforward language and making use of charts and examples, Passarelli explains how to use the greeks to be a better options trader.

Leseprobe

Table of Contents

Praise

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Title Page

Copyright Page

Dedication

DISCLAIMER

Acknowledgements

Foreword

Introduction

Changes in the Market

A New Direction

Trading Option Greeks

Options and Opportunity

The Challenges of Options

Using This Book

Part I - The Basics of Option Greeks

Chapter 1 - The Basics

Contractual Rights and Obligations

ETFs, Indexes, and HOLDRs

Strategies and At-Expiration Diagrams

Chapter 2 - Greek Philosophy

Price vs. Value: How Traders Use Option-Pricing Models

Delta

Gamma

Theta

Vega

Rho

Where to Find Option Greeks

Thinking Greek

Chapter Notes

Chapter 3 - Understanding Volatility

Historical Volatility

Implied Volatility

Expected Volatility

Implied Volatility and Direction

Calculating Volatility Data

Chapter Note

Chapter 4 - Option-Specific Risk and Opportunity

Long ATM Call

Long OTM Call

Long ITM Call

Long ATM Put

It’s All About Volatility

Options and the Fair Game

Chapter 5 - An Introduction to Volatility-Selling Strategies

Profit Potential

Chapter 6 - Put-Call Parity and Synthetics

American Exercise Options

Synthetic Stock Strategies

Theoretical Value and the Interest Rate

Conclusion

Chapter Note

Chapter 7 - Rho

Rho and Interest Rates

Rho and Time

Considering Rho When Planning Trades

Trading Rho

Chapter Notes

Chapter 8 - Dividends and Option Pricing

Dividend Basics

Dividends and Option Pricing

Dividends and Early Exercise

Inputting Dividend Data into the Pricing Model

Chapter Notes

Part II - Spreads

Chapter 9 - Vertical Spreads

Vertical Spreads

Verticals and Volatility

The Interrelations of Credit Spreads and Debit Spreads

Chapter Note

Chapter 10 - Wing Spreads Condors and Butterflies

Taking Flight

Keys to Success

Greeks and Wing Spreads

Constructing Trades to Maximize Profit

The Retail Trader versus the Pro

Chapter Notes

Chapter 11 - Calendar and Diagonal Spreads

Calendar Spreads

Trading Volatility Term Structure

Diagonals

The Strength of the Calendar

Chapter Note

Part III - Volatility

Chapter 12 - Delta-Neutral Trading Trading Implied Volatility

Direction Neutral versus Direction Indifferent

Delta Neutral

Trading Implied Volatility

Chapter 13 - Delta-Neutral Trading Trading Realized Volatility

Gamma Scalping

Gamma Hedging

Smileys and Frowns

Conclusions

Chapter 14 - Studying Volatility Charts

Nine Volatility Chart Patterns

Chapter Note

Part IV - Advanced Option Trading

Chapter 15 - Straddles and Strangles

Long Straddle

Short Straddle

Synthetic Straddles

Long Strangle

Short Strangle

Chapter Note

Chapter 16 - Complex Spreads

Ratio Spreads

How Market Makers Manage Delta-Neutral Positions

Reacting to Volatility

When Delta Neutral Isn’t Direction Indifferent

Managing Multiple-Class Risk

Chapter 17 - The Trader’s Thought Process

Protect Yourself

Index

About the Author

About Bloomberg

Praise forTrading Option Greeks

How Time, Volatility, and Other Pricing Factors Drive Profit

by Dan Passarelli

“A must-read for individuals who are serious about trading options”

—James Bittman Author, Trading Options as a Professional

“Dan’s book is a primer for options aficionados. Without bogging you down with superheavy math, he walks you through the key principles and shows you what matters the most to your trading portfolio.”

—Fari Hamzei Founder, Hamzei Analytics, LLC

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Attention Corporations

This book is available for bulk purchase at special discount. Special editions or chapter reprints can also be customized to specifications. For information, please e-mail Bloomberg Press, [email protected], Attention: Director of Special Markets, or phone [phone].

© by 2008 Dan Passarelli. All rights reserved. Protected under the Berne Convention. No part of this book may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher except in the case of brief quotations embodied in critical articles and reviews. For information, please write: Permissions Department, Bloomberg Press, 731 Lexington Avenue, New York, NY 10022 or send an e-mail to [email protected].

BLOOMBERG, BLOOMBERG ANYWHERE, BLOOMBERG.COM, BLOOMBERG MARKET ESSENTIALS, Bloomberg Markets, BLOOMBERG NEWS, BLOOMBERG PRESS, BLOOMBERG PROFESSIONAL, BLOOMBERG RADIO, BLOOMBERG TELEVISION, and BLOOMBERG TRADEBOOK are trademarks and service marks of Bloomberg Finance L.P. (“BFLP”), a Delaware limited partnership, or its subsidiaries. The BLOOMBERG PROFESSIONAL service (the “BPS”) is owned and distributed locally by BFLP and its subsidiaries in all jurisdictions other than Argentina, Bermuda, China, India, Japan, and Korea (the “BLP Countries”). BFLP is a wholly-owned subsidiary of Bloomberg L.P. (“BLP”). BLP provides BFLP with all global marketing and operational support and service for these products and distributes the BPS either directly or through a non-BFLP subsidiary in the BLP Countries. All rights reserved.

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This publication contains the author’s opinions and is designed to provide accurate and authoritative information. It is sold with the understanding that the author, publisher, and Bloomberg L.P. are not engaged in rendering legal, accounting, investment-planning, or other professional advice. The reader should seek the services of a qualified professional for such advice; the author, publisher, and Bloomberg L.P. cannot be held responsible for any loss incurred as a result of specific investments or planning decisions made by the reader.

Library of Congress Cataloging-in-Publication Data

Passarelli, Dan.

Trading option greeks: how time, volatility, and other pricing factors drive profit/Dan Passarelli; foreword by William J. Brodsky.

p. cm.

Includes index.

Summary: “Trading Option Greeks shows how to unlock the power of greeks trading by applying the unique characteristics of options, including volatility, time, delta, and more. Veteran floor trader and trainer to thousands, Dan Passarelli provides specific strategies and details on how to use spreads to take advantage of changes in the greeks”—Provided by publisher.

ISBN 978-1-57660-246-1 (alk. paper)

1. Options (Finance) 2. Stock options. 3. Derivative securities. I. Title.

HG6024.A3P36 2008

332.64’53—dc22

2008016643

This book is dedicated to Kathleen, Sam, and Isabel. I wouldn’t trade them for all the money in the world.

DISCLAIMER

This book is intended to be educational in nature, both theoretically and practically. It is meant to generally explore the factors that influence option prices so that the reader may gain an understanding of how options work in the real world. This book does not prescribe a specific trading system or method. It is surely not a recipe for getting rich quick.

Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Examples may or may not be based on factual or historical data.

In order to simplify the computations, examples may not include commissions, fees, margin, interest, taxes or other transaction costs. Commissions and other costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax adviser about potential tax consequences. Past performance is not a guarantee of future results.

Options involve risks and are not suitable for everyone. Although much of this book focuses on the risks involved in option trading, there are market situations and scenarios that involve unique risks that are not discussed. Prior to buying or selling an option, a person should read Characteristics and Risks of Standardized Options (ODD). Copies of the ODD are available from your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation, One North Wacker Drive, Chicago, Illinois 60606.

Acknowledgments

A book like Trading Option Greeks is truly a collaboration of the efforts of many people. In my years as a trader I had many teachers in the School of Hard Knocks. I have had the support of friends and family during the trials and tribulations throughout my trading career, as well as during the time spent writing this book. Surely there are hundreds of people whose influences contributed to the creation of this book, but there are a few in particular to whom I’d like to give special thanks.

I’d like to give a very special thanks to my mentor and friend from the CBOE’s Options Institute, Jim Bittman. Without his help this book would not have been written. Thanks to Marty Kearney and Joe Troccolo for looking over the manuscript. Their input was invaluable. Thanks to Debra Peters for her help during my career at the Options Institute. Thanks to Bob Kirkland and the late Steve Fossett for believing in me. Thanks to the staff at Bloomberg Press, especially Stephen Isaacs and Evan Burton. Thanks to my friends at the Chicago Board Options Exchange, the Options Industry Council, and the CME group. Thanks to my wife, Kathleen, who has been more patient and supportive than anyone could reasonably ask for. And thanks, especially, to my students and those of you reading this book.

There are also a few websites that are full of valuable tools and information that deserve special mention: The Option Industry Council’s website, 888options.com; The Chicago Board Option Exchange’s site, cboe.com; iVolatility.com; and www.hoadley.net.

Foreword

Today’s option markets are the tightest, most liquid, and most actively traded markets in the history of listed-options trading. This thriving trading environment has led to greater competition among market makers and market takers alike. Such robust competition almost always creates opportunities for traders, and today’s options markets are no exception. It is truly a great time to be an options trader. However, in order to succeed, today’s options traders have to be smarter than ever before.

Over the past several years, many esteemed options experts have written books on options basics. In fact, the beneficiaries of this knowledge have helped contribute to the recent surge in trading activity. However, in order to compete in today’s rapidly evolving marketplace, new entrants must be armed with more knowledge than those who began trading even a few years earlier needed. Dan Passarelli’s book Trading Option Greeks provides traders with the knowledge to successfully navigate today’s option markets, which include a host of new products, strategies, and rules.

When retail portfolio margining was introduced, in early 2007, the playing field was largely leveled for small retail traders and big professionals. Before portfolio margining, retail traders were inhibited by high margin requirements and often couldn’t trade the same strategies as professionals do. Now the only barrier to a retail trader’s trading some of the advanced strategies previously reserved for professional traders is knowledge.

Options markets have also seen a seismic shift in the new-product area, most notably with the emergence of volatility as an asset class. Options traders have long relied on the VIX (the Chicago Board Options Exchange Volatility Index) to measure market volatility, but with CBOE’s launch of options on VIX, in 2006, today’s options traders can now trade volatility itself. VIX options quickly became among the most successful new products in the history of the industry, and CBOE has since rolled out an entire suite of volatility products.

Dan helps prepare traders for this new, more sophisticated options arena. Throughout this book, he discusses extensively the time component of options prices. Several chapters discuss in great depth trading volatility, put-call parity, rho (or interest rate risk), and dividends.

Few books discuss the advanced concepts of options pricing as Trading Option Greeks does. Those that do tend to take a strictly mathematical or academic approach. Dan offers a practical approach that illustrates how the reader can apply the concepts to real-world trading scenarios.

Throughout Trading Option Greeks, Dan conveys a perspective unlike that of most other authors: that of a market maker. Dan traded as a market maker on the floor of the CBOE for seven years. Following his floor-trading career, he began sharing his insights with retail and institutional traders as an instructor with the CBOE’s Options Institute. Dan writes from a unique perspective from which traders of all experience levels can benefit, making Trading Option Greeks a must-read for option traders.

WILLIAM J. BRODSKY Chairman and CEOChicago Board Options Exchange

Introduction

The first listed options contract was traded on the Chicago Board Options Exchange. Chicago is, incidentally, the home of the well-known Union Stockyards, which thrived in the latter half of the 1800s and first half of the 1900s. The stockyards prided themselves on having very little waste from their slaughterhouses. They were said to use “everything but the squeal.” The options and futures markets, having evolved out of the agricultural and livestock industries, still hold that mentality. The concept of seizing all opportunities has always been part of the derivatives culture. This mentality allows traders to maximize their profits by taking into account everything they see in the market and wasting no opportunity.

The need to seize opportunities that don’t always fit into the traditional paradigm has led to the growth and success of the options market. In recent years, from 2000 to 2005, average daily trading volume for exchange-listed options increased a total of around 107 percent. Average daily volume for stocks listed on the New York Stock Exchange increased by a total of about 53 percent during that same period. In late 2007, growth in option volume was still continuing to outpace growth in stock volume.

From the outside looking in, the esoteric game of the Wall Street or LaSalle Street trader seems to be a world away from a stay-at-home trader with an online, self-directed trading account. In the past, these were two mutually exclusive groups, but now the lines are blurring.

It is easy to assume that market makers and other professional traders have closely kept secrets to their ways of trading. In fact, nothing could be further from the truth. If there are any “secrets” of professional traders, this book will expose them. The real wall between the options pro and the average Joe was built from other inequities: commissions, bid-ask spreads, and margin requirements. This wall is crumbling.

Changes in the Market

The bid-ask spread for a typical options contract in 1998, when I started trading as a market maker, was a great deal wider than it is today. This hidden transaction cost coupled with high commissions made multiple-leg strategies simply untradable for the average trader. Fierce competition among the exchanges signifi cantly tightened the widths of these spreads as multiple listings of options heated up around the turn of the century. In 2007, the Penny Pilot Program made it possible for some option classes to trade in minimum tick increments of one cent, allowing for even tighter spreads. The narrowing of the bid-ask spread has been a challenge for market makers but great for market takers. When commissions fell and bid-ask spreads narrowed, the doors opened for off-fl oor traders (both retail and professional) to trade multiple-legged option strategies.

The latest and perhaps greatest change in the options market is the advent of portfolio margining. Retail portfolio margining allows savvy traders, who have been disenfranchised over the years with oppressive margin requirements, to trade strategies traditionally only professional traders had the practical means to trade.

A New Direction

Traders, both professional and retail, need ways to act on their forecasts without the constraints of convention. “Get long, or do nothing” is no longer a viable business model for people active in the market. “Up is good; down is bad” is burned into traders’ minds from the beginning of their market education. This concept has its place in the world of investing, but becoming an active trader in the option market requires thinking in a new direction.

Market makers and other expert option traders look at the market differently from other traders. Ultimately, the fundamental difference is that these traders trade all four directions: up, down, sideways, and volatile.

UPS AND DOWNS

In what became known as the tech bubble of the late 1990s, I was fortunate enough to find myself surrounded by market geniuses. These gurus were traders, brokers, doctors, lawyers, computer programmers, plumbers, cab drivers, housewives, waitresses, and aerobics instructors—to name just a few. They all had success stories.

One of the hardest lessons to learn in trading is how to lose money. Those who have opened a Wall Street Journal since the 1990s tech bubble may have noticed that all stocks don’t always go up. If they did, this would be a very short book. Unfortunately for many of the dot-com profiteers, they learned this the hard way. The market giveth, and the market taketh away.

TRADING STRATEGIES

Buying stock is a trading strategy that most people understand. In practical terms, traders who buy stock are generally not concerned with the literal ownership stake in a corporation, just the opportunity to profit if the stock rises. Although it’s important for traders to understand that the price of a stock is largely tied to the success or failure of the corporation, it’s essential to keep in mind exactly what the objective tends to be for trading a stock: to profit from changes in its price. A bullish position can also be taken in the options market. The most basic example is buying a call.

A bearish position can be taken by trading stock or options, as well. If traders expect the value of a stock they own to fall, they will sell the stock. This eliminates the risk of losses from the stock falling. If the traders do not own the stock that they think will decline, they can take a more active stance and short it. The short-seller borrows the stock from a party that owns it and then sells the borrowed shares to another party. The goal of selling stock short is to later repurchase the shares at a lower price before returning the stock to its owner. It is simply reversing the order of “buy low/sell high.” The risk is that the stock rises and shares have to be bought at a higher price than that at which they were sold. Although shorting stock can lead to profits when the market cooperates, in the options market, there are alternative ways to profit from falling prices. The most basic example is buying a put.

Trading Option Greeks

A trader can use options to take a bullish or bearish position, given a directional forecast. Sideways, nontrending stocks and their antithesis, volatile stocks, can be traded as well. In the later market conditions, profit or loss can be independent of whether the stock rises or falls. Opportunity in option trading is not necessarily black and white—not necessarily up and down. Option trading is nonlinear. Consequently, more opportunities can be exploited by trading options than by trading stock.

Option traders must consider the time period in question, the volatility expected during this period, interest rates, and dividends. Along with the stock price, these factors make up the dynamic components of an option’s value. These individual factors can be isolated, measured, and exploited. Incremental changes in any of these elements provide opportunity for option traders. Option greeks is the term used for the way the incremental changes in factors affecting an option price are measured. Because of these other influences, direction is not the only tradable element of a forecast. Time, volatility, interest rates—these can all be traded using options. These factors will all be discussed at great length throughout this book.

Options and Opportunity

Options are derivative instruments, meaning their prices are derived from the prices of other securities. This book will discuss options in the context of equities, exchange-traded funds (ETFs), and indexes—although many of the concepts can be applied to Treasuries, foreign exchange, and commodities as well. The concepts apply to both traders and investors. Ultimately, options are all about risk. Traders and investors can use these risk-centric instruments as a means to achieve many different objectives. They can use them to limit risk or as a way to increase risk with the objective of achieving higher returns.

LIMITING RISK

Limiting risk is the primary economic purpose for options. Individual and institutional investors can use this tool as a veritable insurance policy on securities they own. The most basic example is the protective put strategy, which will be discussed in greater detail in the first chapter. With the protective put, investors buy put options to protect long stock positions when they believe the stock will be volatile. In this instance, the investors retain a bullish outlook. But when buying this “insurance,” traders have to look at the big picture. They need to think about their expectations of volatility and the time period of perceived risk. In augmenting the long stock position with the put, hedgers have a fundamentally different position from simply being long the security. The new position must be managed accordingly; it’s not purely directional.

This book will describe how to analyze hedging strategies to develop reasonable expectations as to what the strategy can and cannot achieve and how most efficiently to implement it. Investment-oriented strategies that will be discussed in this book include hedging strategies, such as buying puts, as well as risk-reducing strategies, such as the covered call.

CREATING RISK

All trading and investing involves risk, but what sensible person would want to create risk? Traders and investors are willing to accept a certain amount of risk in hopes of achieving a certain amount of reward. In stock trading, more aggressive traders will often buy stocks on margin, accepting greater risk to attempt to reap a greater reward. Conventional margining in the U.S., at the time of this writing, allows a trader to borrow up to 50 percent of the value of the stock being purchased. Double the risk, double the reward. This is called leverage.

The options market provides many opportunities for leverage. Traders can, for example, buy a call or a put to take a bullish or bearish position, respectively, with far less capital at stake than would be in taking the same stance using the underlying security, even on margin. They can use this lower cash outlay to control a more leveraged position (that is, use the cash saved to buy more options) when seeking to be more aggressive and accept more risk. Traders can create an option position with a unique risk-reward profile often superior to that of a position in the stock sharing similar directional risk. A trader’s objectives will dictate the right strategy for the right situation.

Traders can tailor a position to fit a specific forecast with respect to the time horizon; the degree of bullishness, bearishness, neutrality, or volatility in the underlying stock; and the desired amount of leverage. Furthermore, they can exploit opportunities unique to options. They can trade option greeks. This opens the door to new opportunities and new challenges.

The Challenges of Options

Having been a market maker, a retail trader, and an instructor in this field, I have seen many option traders come and go. Generally speaking, the traders with the greatest amount of confidence in their positions are the ones who have tended to fall fastest and hardest. There is no room for optimism in option trading. A trader can be optimistic about the prospects for overall success, but not about each individual position working out favorably. No trader is always right. This seems obvious to many but comes as a shock to some. In fact, some of the best traders are wrong as often as—and sometimes more often than—they are right.

No matter what our instincts tell us, we do not know what will happen in the future with regard to the market. As Socrates put it, “The only true wisdom is in knowing you know nothing.” The masters of option trading know more about understanding the nature of probability in the market than in predicting market direction.

Using This Book

This book addresses the complex price behavior of options by discussing option greeks from both a theoretical and a practical standpoint. There is some tactical discussion throughout, although the objective of this book is to provide education to the reader. This book is meant to be less a how-to manual than a how-come tutorial.

This informative guide will give the retail trader a look inside the mind of a professional trader. It will help the professional trader better understand the essential concepts of his craft. Even the novice trader will be able to apply these concepts to basic options strategies. Comprehensive knowledge of the greeks can help traders to avoid common pitfalls and increase profit potential.

Choosing the right strategy makes all the difference. During my time as an instructor at the Chicago Board Options Exchange, I talked to many traders who were new to options and who told me, “I made a trade based on what I thought was going to happen. I was right, but my position lost money!” Knowing which option strategy is the right strategy for a given situation comes with knowledge and experience. The more strategies you master, the more of an advantage you have as a trader with more weapons in your arsenal.

At some point, it becomes clear that it doesn’t matter what the strategy is called or how familiar it is. All that ultimately matters is the exposure one has to the market as measured by risk at expiration and the position greeks.

Much of this book is broken down into a discussion of individual strategies. Although, again, the nuances of each specific strategy are not relevant, presenting the material this way allows for a discussion of very specific situations in which greeks come into play. Many of the concepts discussed in a section on one option strategy can be applied to other option strategies.

Chapter 1 discusses basic option concepts and definitions. It was written to be a review of the basics for the intermediate to advanced trader. For newcomers, it’s essential to understand these concepts before moving forward.

A detailed explanation of option greeks begins in Chapter 2. Be sure to leave a bookmark in this chapter, as you will flip to it several times while reading the rest of the book and while studying the market thereafter. Chapter 3 introduces volatility. The same bookmark advice can be applied here, as well. Chapters 4 and 5 explore the minds of options traders. What are the risks they look out for? What are the opportunities they seek? These chapters also discuss direction-neutral and direction-indifferent trading. The remaining chapters take the reader from concept to application, discussing the strategies for nonlinear trading and the tactical considerations of a successful options trader.

Part I

The Basics of Option Greeks

Chapter 1

The Basics

TO UNDERSTAND HOW OPTIONS WORK, one needs first to understand what an option is. An option is a contract that gives its owner the right to buy or the right to sell a fixed quantity of an underlying security at a specific price within a certain time constraint. There are two types of options: calls and puts. A call gives the owner of the option the right to buy the underlying security. A put gives the owner of the option the right to sell the underlying security. As in any transaction, there are two parties to an option contract—a buyer and a seller.

Contractual Rights and Obligations

The option buyer is the party who owns the right inherent in the contract. The buyer is referred to as having a long position and may also be called the holder, or owner, of the option. The right doesn’t last forever. At some point the option will expire. At expiration, the owner may exercise the right or, if the option has no value to the holder, let it expire without exercising it. But he need not hold the option until expiration. Options are transferable—they can be traded intraday in much the same way as stock is traded. Because it’s uncertain what the underlying stock price of the option will be at expiration, much of the time this right has value before it expires. The uncertainty of stock prices, after all, is the raison d’être of the option market.