Trading Options Greeks

How Time, Volatility, and Other Pricing Factors Drive Profits

Dan Passarelli

• Publisher: Bloomberg Press
• Year: 2012
• ISBN:
  9781118238615
• Edition: 2
• Topic: Business
• Subtopic: Finance
• Index: Business

A top options trader details a practical approach for pricing and trading options in any market condition

The options market is always changing, and in order to keep up with it you need the greeks—delta, gamma, theta, vega, and rho—which are the best techniques for valuing options and executing trades regardless of market conditions. In the Second Edition of Trading Options Greeks, veteran options trader Dan Pasarelli puts these tools in perspective by offering fresh insights on option trading and valuation.

An essential guide for both professional and aspiring traders, this book explains the greeks in a straightforward and accessible style. It skillfully shows how they can be used to facilitate trading strategies that seek to profit from volatility, time decay, or changes in interest rates. Along the way, it makes use of new charts and examples, and discusses how the proper application of the greeks can lead to more accurate pricing and trading as well as alert you to a range of other opportunities.

• Completely updated with new material
• Information on spreads, put-call parity and synthetic options, trading volatility, and advanced option trading is also included
• Explores how to exploit the dynamics of option pricing to improve your trading

Having a comprehensive understanding of the greeks is essential to long-term options trading success. Trading Options Greeks, Second Edition shows you how to use the greeks to find better trades, effectively manage them, and ultimately, become more profitable.

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 party to the contract who is referred to as 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 potentially 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 statistically 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—they are equally common.

Opening and Closing

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 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. Often, volume is stated on a one-day basis, but could be stated per week, month, year, or otherwise. Once a new period (day) begins, volume begins again at zero. 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 had no position to start with, 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 OCC ultimately guarantees every options trade. In 2010, that was almost 3.9 billion listed-options 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 trade 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 counterparty 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 170 call at 5.00

Quantity

In this example, one contract is being purchased. More could have been purchased, but not less—options cannot be traded in fractional units.

Option Series, Option Class, and Contract Size

All calls or puts of the same class, the same expiration month, and the same strike price are called an option series. For example, the IBM December 170 calls are a series. Options series are displayed in an option chain on an online broker’s user interface. An option chain is a full or partial list of the options that are listed on an underlying.

Option class means a group of options that represent the same underlying. Here, the option class is denoted by the symbol IBM—the contract represents rights on International Business Machines Corp. (IBM) shares. 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. Though this is usually the case, there are times when the contract size is something other than 100 shares of a stock. This situation may occur after certain types of stock splits, spin-offs, or stock dividends, for example. In the minority of cases in which the one contract represents rights on something besides 100 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 100 shares of the new Ford stock; XFO represented 100 shares of Ford plus $20 per share ($2,000) plus cash in lieu of $1.24; and FOD represented 100 shares of new Ford, 13 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 OCC. 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 ...