Introduction into Options Trading Lesson 3
Hi Steemians,
today we talk about the Options Greeks and other important risk parameters.
If you have missed the first two lessons of this course, you can read them here:
https://steemit.com/money/@stehaller/introduction-into-option-trading-lesson-1
https://steemit.com/money/@stehaller/introduction-into-option-trading-lesson-2
First let’s have a look at the Greeks.
The Greeks are important parameters in options pricing:
Beta, Delta, Gamma, Theta and Vega.
There are more Greeks, but the five I mentioned are the ones you should focus on as an options trader.
So let’s have a look at every single one of them:
1. Beta:
Beta allows you to weight your position with a benchmark. The best benchmark to beta weight your position against, is the S&P 500 Index (SPY). Beta weighting your whole portfolio against the SPY helps you to understand how your portfolio will change with a certain move in the market. If you beta weight your portfolio against the SPY, it will show you how many SPY deltas (more on deltas in the next paragraph) you have on.
So let’s say, after beta weighting against the SPY, your account shows you, that you have 100 long SPY deltas on. This means that when the price of SPY moves up by a dollar, your portfolio should gain $100 in value.
Good brokers like https://www.tastyworks.com automatically beta weight your position against the SPY.
As a premium seller you should always try to be as delta neutral as possible, since stock markets are random and nobody can predict, where the price of a stock or an index will be in the future.
2. Delta:
Delta is the most important Greek.
Delta gives us three different important informations:
a. Directional exposure:
Delta shows you the theoretical rate of change of an option’s price if the underlying stock price moves by $1.Stocks have always a delta of 1.
So if you own 100 shares of SPY, you gain $100, if the price of SPY moves up by $1 and you lose $100, if the price of SPY goes down by $1.
Options can have a delta ranging from zero to 1.
Let’s have a look at an example:
At the time of this writing SPY is trading at 264.42.
The March 256 out of the money put has a delta of 0.30 (times 100 since one option contract covers 100 shares of the underlying stock).
So in theory, if the price of SPY moves up by $1 this 256 put should lose 30 cents in value (times 100, so $30) and if the price of SPY goes down by $1, this option contract should gain 30 cents in value.
b. Delta shows you the number of shares of the underlying stock you need to buy or sell, in order to hedge your position:
Let’s use the example from above:
SPY March 256 put.
If you sell to open this 256 put, you are long 30 deltas (as we learned in the previous lesson ,a put is a bearish position, but if you are short a put, you are getting long delta exposure. So a short put is a long position).
Your beta weighted position against the SPY shows you, that you are long 30 shares of SPY.
So if you want to neutralize your 30 long deltas, you need to sell short 30 shares of SPY (or a 30 delta call, or two 15 delta calls, etc.)
c. Delta shows you the probability, that your option closes in the money at expiration:
The 30 delta put in the example above has a 30% chance of closing its at expiration.
As we learned in the last lesson, stock prices fall within 1 standard deviation 68% of the time. So to find out what one standard deviation move will be in March expiration, we just have to find the 16 delta call and the 16 delta put.
Here is the 16 delta call:
And here is the 16 delta put:
So the 16 delta call is the call with the 277 strike price and the 16 delta put is the put with the 245 strike price.
Due to the put skew, the put is farer away from the at the money strike than the call.
If we sell this 16 delta call and put, we create a one standard deviation strangle (more on strangles in a later lesson).
3. Gamma:
Gamma shows you, how the delta of an option changes, if the underlying stock moves by a dollar. Gamma only really kicks in by the end of the expiration cycle.
So if you own a very long dated option. The price and delta won’t change too much, when the underlying stock moves. But if your option only has left 7 days or left, you can have really big moves.
As a premium seller you should always close or roll your short options, when they have left about 21 days until expiration. This way, gamma won’t hurt you too much.
4. Theta:
Theta is a premium sellers bread and butter. Theta is what a premium seller lives on.
When we sell option premium ,we are long theta.
Theta shows you the daily decay of an option’s extrinsic value.
Out of the money options have only extrinsic value. So if we sell otm options and the price of the underlying price doesn’t hit the strike price, the price of the option decays a bit every day. That’s what we want, since we want to sell options when they are relatively expensive and want to buy them back cheap.
Long options have negative theta, so if their price doesn’t move in the right direction pretty fast, they lose money. So if you want to buy long options, you always sell another option against it, to neutralize the theta decay or get even positive theta. I will show you how to do this in a later lesson.
Theta is a very theoretical concept, it changes by price movements in the underlying stock and when the implied volatility changes.
A good rule of thump as a premium seller, is to collect at least 0.1% of daily theta decay per day on your overall portfolio.
So if you have an $100,000 account, your daily theta should be at least $100. So if nothing happens in the markets, your portfolio grows by $100 a day.
But your daily portfolio theta should never exceed 1%, otherwise you are taking way too much risk.
5. Vega:
Vega is the greek, which shows you the change in an option’s price, if the implied volatility moves by 1%.
Long options have a positive vega and short options have a negative vega.
As a premium seller, you are short vega. When the implied volatility explodes, like it did on Monday Februar 5th 2018, you get hurt pretty bad. So in order to hedge your vega risk, you need to have some short delta/long vega positions, like put spreads, put diagonals, put calendar spreads or simply short SPY stock or short S&P 500 futures.
As a rule of thumb your short vega/short delta ratio should be 2/1.
So if you are short 100 vega in your portfolio, you need about 50 short SPY deltas to hedge this position. Especially in a low implied volatility environment.
Now you know everything you need to know about the Greeks, but there are some more important metrics, which you need to be aware of, in order to trade successfully.
6. Implied Volatility Rank:
We talked about implied volatility in the last lesson.
Implied volatility rank (IVR) shows you, if the actual implied volatility is high or low compared to where it has been during the last year. IVR ranges from 0 (low) to 100 (high).
Since we already have learned, that options are expensive when the implied volatility is high, we wanna sell options in an high IVR environment.
Great brokers like tastyworks, show you the IVR of every underlying:
So at the moment the IVR in SPY is 53%.
Anything over 50% is considered high.
7. VIX:
Another important indicator to gauge the implied volatility is the VIX.
The VIX is the CBOE market volatility index and it measures the implied volatility of the S&P 500 index for the next 30 days. It is expressed as an annualized percentage.
So if the VIX is at 25, the options market is expecting a 25% move in the S&P 500 index in the next 365 days.
It is often called the fear indicator, since when stock prices plummet, the VIX rises.
You can’t trade the VIX, but there are options on the VIX, but their strike prices are not derived of the VIX itself, but of the VIX-Future (ticker: /VX).
If you wanna find out the price of the VIX-Future, but don’t have access to futures quotes, just look at the VIX options chain and try to find out the strike price, where the puts and calls trade roughly for the same price.
The relationship of the SPX, the VIX, the /VX and VIX options might sound complicated for someone new to trading, but don’t worry too much about it, just remember when the VIX is high, the options market in the S&P 500 is pricing in a big move and therefore option prices are expensive. A premium seller’s dream.
There are also a volatility indexes for other underlyings:
Russell 2000 Index: RVX
Nasdaq 100 Index: VXN
Gold: GVZ
Oil: OVX
Treasury Bonds: TYVIX
Lest I forget, just one warning:
Never sell naked calls in the VIX or short VIX-Futures!!!
It can wipe out your account. Just look how the VIX exploded last week.
8. Correlation:
In order to not get wiped out by one giant move in one underlying, you need to diversify your portfolio in a lot of different uncorrelated underlying equities and different strategies.
Like I said in my previous lesson, as a premium seller you are like a casino.
You have a statistical edge, but you need lots of small trades in uncorrelated underlying stocks, in order to make the probabilities work out.
Therefore you need to look at the correlation between the underlying equities.
I don’t know about other brokers, but tastyworks shows you the correlation between the SPY and any other stock.
The correlation ranges from -1 to +1.
For example if you have long deltas in AAPL, FB and QQQ you are not diversified, since all of these underlyings are highly correlated, meaning they tend to move in the same direction.
So you either need to diversify by strategy, for example a short delta play in AAPL, a long delta play in FB and a delta neutral strategy in QQQ, or you need to find different underlyings.
The four most uncorrelated products I like to trade are IWM (=Russell 2000 ETF), TLT (20+ year bond ETF), GLD (Gold) and XLE (=Energy sector ETF).
Well, again we covered a lot today.
You now know all the theoretical stuff behind options.
In the next lesson we look into the most important concepts and strategies in options trading.
If you liked my lesson, please upvote and resteem and if you have any questions, feel free to ask.
Have a wonderful day,
Stephan Haller
P.S. I can’t stress this enough, if you want to learn more about options, go to https://www.tastytrade.com/tt/ (No, I’m not getting paid to advertise this channel, but it is the best source on the internet and it’s free)