Trading Option Greeks

How Time, Volatility, and Other Pricing Factors Drive Profit

Dan Passarelli

• Publisher: Bloomberg Press
• Year: 2010
• Print ISBN: 9781576602461
• eBook ISBN: 9780470885192
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

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.

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.

A long position in an option contract, however, is fundamentally different from a long position in a stock. Owning corporate stock affords the shareholder ownership rights, which may include the right to vote in corporate affairs and the right to receive dividends. Owning an option represents strictly the right either to buy the stock or to sell it, depending on whether it’s a call or a put. Option holders do not receive dividends that would be paid to the shareholders of the underlying stock, nor do they have voting rights. The corporation has no knowledge of the parties to the option contract. The contract is created by the buyer and seller of the option and made available by being listed on an exchange.

The option seller, also called the option writer, has a short position in the option. Instead of having a right to take a position in the underlying stock, as the buyer does, the seller incurs an obligation to either buy or sell the stock. When a trader who is long an option exercises, a trader with a short position gets assigned. Assignment means the trader with the short option position is called on to fulfill the obligation that was established when the contract was sold.

Shorting an option is fundamentally different from shorting a stock. Corporations have a quantifiable number of outstanding shares available for trading, which must be borrowed to create a short position, but establishing a short position in an option does not require borrowing; the contract is simply created. The strategy of shorting stock is implemented far less frequently than simply buying stock, but that is not at all the case with options. For every open long-option contract, there is an open short-option contract.

OPENING AND CLOSING

Option traders need to concern themselves with many issues that conventional stock traders don’t, and one of them arises before the trade is even entered into. Traders’ option orders are either opening or closing transactions. When traders with no position in a particular option buy the option, they buy to open. If, in the future, the traders wish to eliminate the position by selling the option they own, the traders enter a sell to close order—they are closing the position. Likewise, if traders with no position in a particular option want to sell an option, thereby creating a short position, the traders execute a sell to open transaction. When the traders cover the short position by buying back the option, the traders enter a buy to close order.

OPEN INTEREST AND VOLUME

Traders use many types of market data to make their trading decisions. Two items that are often studied but sometimes misunderstood are volume and open interest. Volume, as the name implies, is the total number of contracts traded during a time period—usually one day. Open interest is the number of contracts that have been created and remain outstanding. Open interest is a running total.

When an option is first listed, there are no open contracts. If Trader A opens a long position in a newly listed option by buying a one-lot, or one contract, from Trader B, who by selling is also opening a position, a contract is created. One contract traded, so the volume is one. Since both parties opened a position and one contract was created, the open interest in this particular option is one contract as well. If, later that day, Trader B closes his short position by buying one contract from Trader C, who has no position, the volume is now two contracts for that day, but open interest is still one. Only one contract exists; it was traded twice. If the next day, Trader C buys her contract back from Trader A, that day’s volume is one and the open interest is now zero.

THE OPTIONS CLEARING CORPORATION

Remember when Wimpy would tell Popeye, “I’ll gladly pay you Tuesday for a hamburger today.” Did Popeye ever get paid for those burgers? In a contract, it’s very important for each party to hold up his end of the bargain—especially when there is money at stake. How does a trader know the party on the other side of an option contract will in fact do that? That’s where the Options Clearing Corporation (OCC) comes into play.

The Options Clearing Corporation ultimately guarantees every options trade. In 2007, that was more than 2.8 billion contracts. The OCC accomplishes this through many clearing members. Here’s how it works: When trader X buys an option through a broker, the broker submits the information to its clearing firm. The trader on the other side of this transaction, Trader Y, who is probably a market maker, submits the trade to his clearing firm. The two clearing firms (one representing Trader X’s buy, the other representing Trader Y’s sell) each submit the trade information to the OCC, which “matches up” the trade.

If Trader Y buys back the option to close the position, how does that affect Trader X if he wants to exercise it? It doesn’t. The OCC, acting as an intermediary, assigns one of its clearing members with a customer that is short the option in question to deliver the stock to Trader X’s clearing firm, which in turn delivers the stock to Trader X. The clearing member then assigns one of its customers who is short the option. The clearing member will assign the trader either randomly or first in, first out. Effectively, the OCC is the ultimate counter-party to both the exercise and the assignment.

STANDARDIZED CONTRACTS

Exchange-listed options contracts are standardized, meaning the terms of the contract, or the contract specifications, conform to a customary structure. Standardization makes the terms of the contracts intuitive to the experienced user.

To understand the contract specifications in a typical equity option, consider an example.

Buy 1 IBM December 95 call at 1.00

Quantity. In this example, one contract is being purchased. Options cannot be traded in fractional units.

Option class and contract size. Option class means a group of options that represent the same underlying. Here, the option class is denoted by the root symbol IBM. The root symbol for IBM’s options happens to be the same as its stock symbol. Although this is often the case, sometimes the stock symbol and the option root symbol will differ. For example, Nasdaq stocks that have four-letter stock symbols will often have option roots represented by three-letter symbols. Buying one contract usually gives the holder the right to buy or to sell 100 shares of the underlying stock. This number is referred to as contract size. There are times, however, when the contract size is something other than one hundred shares of a stock. This situation may occur after certain types of stock splits or spinoffs, for example. In the minority of cases in which the one contract represents rights on something besides one hundred shares, there may be more than one class of options listed on a stock.

A fairly unusual example was presented by the Ford Motor Company options in the summer of 2000. In June 2000, Ford spun off Visteon Corporation. Then in August 2000 Ford offered shareholders a choice of converting their shares into (a) new shares of Ford plus $20 cash per share, (b) new Ford stock plus fractional shares with an aggregate value of $20, or (c) new Ford stock plus a combination of more new Ford stock and cash. There were three classes of options listed on Ford after both of these changes: F represented one hundred shares of the new Ford stock; XFO represented one hundred shares of Ford plus $20 per share ($2,000) plus cash in lieu of $1.24; and FOD represented one hundred shares of new Ford, thirteen shares of Visteon, and $2,001.24. Sometimes these changes can get complicated. If there is ever a question as to what the underlying is for an option class, the authority is the Options Clearing Corporation. A lot of time, money and stress can be saved by calling the OCC at 888-OPTIONS and clarifying the matter.

Expiration month. Options expire on the Saturday following the third Friday of the stated month, which in this case is December. The final trading day for an option is commonly the day before expiration—here, the third Friday of December. There are usually at least four months listed for trading on an option class. There may be a total of six months if Long-Term Equity AnticiPation Securities^® or LEAPS^® are listed on the class. LEAPS can have one year to about two and a half years until expiration. Some indexes have one-week options called Weeklys^SM listed on them.

Strike price. The price at which the option holder owns the right to buy or to sell the underlying is called the strike price, or exercise price. In this example, the holder owns the right to buy the stock at $95 per share. There is method to the madness regarding how strike prices are listed. Stocks that are priced above $200 a share usually have strikes listed that are $10 apart. Stocks between $25 and $200 have strikes listed in $5 increments. Stocks below $25 have strikes listed in $2.50 increments. And there are many stocks trading below $20 that have $1 strikes.

The relationship of the strike price to the stock price is important in pricing options. For calls, if the stock price is above the strike price, the call is in-the-money (ITM). If the stock and the strike prices are close, the call is at-the-money (ATM). If the stock price is below the strike price the call is out-of-the-money (OTM). This relationship is just the opposite for puts. If the stock price is below the strike price, the put is in-the-money. If the stock price and the strike price are about the same, the put is at-the-money. And, if the stock price is above the put strike, it is out-of-the-money.

Option type. There are two types of options: calls and puts. Calls give the holder the right to buy the underlying and the writer the obligation to sell the underlying. Puts give the holder the right to sell the underlying and the writer the ...

Table of contents

• Praise
• Related titles also available from BLOOMBERG PRESS
• Title Page
• Copyright Page
• Dedication
• DISCLAIMER
• Acknowledgements
• Foreword
• Introduction
• Part I - The Basics of Option Greeks
• Part II - Spreads
• Part III - Volatility
• Part IV - Advanced Option Trading
• Index
• About the Author
• About Bloomberg