Options 02 (Oct 09 - Dec 24)

[teachme]

I guess somebody should give you face for the effort you put in to educate us.
As usual, after losing buying those SPY put options recently, I have been reading up on options. So, here are my answers. Took me some time as I had to constantly refer back to my book.

MCQs :
SPY is at 109.82 on 19Nov09

a) Delta of (Dec09 105 Call) > Delta of (Feb2010 105 Call)
b) Delta of (Dec09 105 Call) < Delta of (Feb2010 105 Call)

Answer: (b)
Call options are out-of-money. Delta is also interpreted as probability of expiring in-the-money. Nearer the expiration date, lower the probability for out-of-money call options to expire in-the-money. Hence, nearer the expiration, lower the delta for out-of-money options.

c) Gamma of (Dec09 100 Put) > Gamma of (Feb2010 100 Put)
d) Gamma of (Dec09 100 Put) < Gamma of (Feb2010 100 Put)

Answer: (d)
This is in-the-money put option. Gamma is rate of change of delta with respect to change in underlying price. When expiry date nears, one becomes more certain that in-the-money options should stay in-the-money as there is lesser time for the option to move out-of-money. Hence, delta should be more stable as expiry date nears. Hence, Gamma should be lower for near-expiry options to give a more stable delta.

e) Theta of (Feb09 110 Call) > Theta of (Feb09 100 Call)
f) Theta of (Feb09 110 Call) < Theta of (Feb09 100 Call)

Answer: e
Theta reaches its peak for at-the-money option.

g) Vega of (Dec09 108 Put) > Vega of (Feb2010 108 Put)
h) Vega of (Dec09 108 Put) < Vega of (Feb2010 108 Put)

Answer: h
As expiry nears, the impact that vega has on the option price should be lesser as there is less time for volatility to swing the option to the other end. Hence, as expiry date nears, vega becomes smaller.

[kennynah]

Hi kennynah,

I hope you would not mind me diverting the options discussion away a bit.
Recently, I made my first options purchase and bought SPY put options (no beginners' luck!! Lost money again!!). Then, I noticed there are SPX options.

May I know what is your preference? SPY and SPX options?

Your posts on option related issues are always very welcome in this thread...

SPY, the ETF, mimics the SPX index very closely. In this regard, the movement of SPY mimics the movement of SPX index. I prefer SPY options for the various reasons :

a) It is less capital intensive
b) It is just as liquid
c) SPY options strikes are dollar wide vs $5 wide for SPX and thus SPY spreads can be less Greeks contrast intensive; eg. Long SPY 110/112 Call has smaller +ve delta, and hence less delta risks, than Long SPX 110/115 Call.

BUT there is a very critical difference between SPY and SPX options. The former is american style options and latter, european options. This becomes important when there are Short options in the portfolio.

Supposing one has a Short SPY option that goes In-The-Money (ITM), there is always the chance that it can get assigned before expiration. SPX options do not face this possibility since, being european style options, they cannot be exercised until expiration, which will be cash settled. This should infer clearly that SPY options are convertible to shares while SPX is just a pure index product and are not "shares".

The basic similarities of SPX and SPY allow them to be employed for "hedging" purposes.

Please let me have your comments on the above. Thanks.

[kennynah]

I guess somebody should give you face for the effort you put in to educate us.
K : teachme, thanks for participating in this quiz and giving me "face" ...hahaha
however, i must debunk this notion that i'm here to educate forummers on options trading...this is far from my intention. i have people calling me numerous names; altruistic is not one of them, and hopefully, neither is egoistical.
additionally, i am not well equipped to educate others in this area.
my purpose of starting and maintaining this thread are multi-folds :

1) by penning down examples and details of options trading, i hone my option trading skills
2) i have always truly hoped to learn from inputs and discussion with other option traders
3) others can spot and correct any of my erroneous option concepts in my posts

MCQs :
SPY is at 109.82 on 19Nov09

a) Delta of (Dec09 105 Call) > Delta of (Feb2010 105 Call)
b) Delta of (Dec09 105 Call) < Delta of (Feb2010 105 Call)

Answer: (b)
Call options are out-of-money. Delta is also interpreted as probability of expiring in-the-money. Nearer the expiration date, lower the probability for out-of-money call options to expire in-the-money. Hence, nearer the expiration, lower the delta for out-of-money options.

K : thanks for the sound concept. with more time to expiration, those far away options which are currently ITM can become OTM later on and those currently OTM have more chance of becoming ITM, when given sufficient time.
here, with SPY trading at ~110, the 105Calls are ITM, and hence answer is a) (which was what you meant) becos the Dec09 105Call has higher chances of staying ITM compared to Feb2010 105Call. ergo, Dec09 105Call has higher "probability" or delta.

c) Gamma of (Dec09 100 Put) > Gamma of (Feb2010 100 Put)
d) Gamma of (Dec09 100 Put) < Gamma of (Feb2010 100 Put)

Answer: (d)
This is in-the-money put option. Gamma is rate of change of delta with respect to change in underlying price. When expiry date nears, one becomes more certain that in-the-money options should stay in-the-money as there is lesser time for the option to move out-of-money. Hence, delta should be more stable as expiry date nears. Hence, Gamma should be lower for near-expiry options to give a more stable delta.

K : i apologise for this trick question. where Gammas are concerned, it doesn't matter whether the options are ITM or OTM, Puts or Calls, all nearer dated options will always have larger Gammas than further out ones. answer is c)

e) Theta of (Feb09 110 Call) > Theta of (Feb09 100 Call)
f) Theta of (Feb09 110 Call) < Theta of (Feb09 100 Call)

Answer: e
Theta reaches its peak for at-the-money option.

K : absolutely right! Theta decay is most severe (largest) with ATM and nearer dated options. answer is e)

g) Vega of (Dec09 108 Put) > Vega of (Feb2010 108 Put)
h) Vega of (Dec09 108 Put) < Vega of (Feb2010 108 Put)

Answer: h
As expiry nears, the impact that vega has on the option price should be lesser as there is less time for volatility to swing the option to the other end. Hence, as expiry date nears, vega becomes smaller.

K : i concur totally. Vegas are always larger for all options when they have more time to expiration. answer is h)

[teachme]

Hi Kennynah,

Thank you very much for your patient correction.

Wah, after reading so much on options, still get 50% just-pass result only. You got face, I no face man!! Cannot even recognize in-the-money, out-of-money option properly. When one's understanding is weak, one cannot see through the trick question except force some answer through some imagined explanation. Really lau-kuay. No wonder I lose money from options recently. Anyway, I'd rather lose face now than lose more money later. Besides, on the internet, we are all faceless. No big deal

[kennynah]

teachme...it has not been easy for me to learn the Greeks either... it can be disconcerting at the beginning. perseverance is required. honestly, i had to re-read Greeks over a period of 2 years before i am able to scratch just the surface. i am a slow learner. others no doubt can grasp the concepts much faster. but whether one is quick or slow to comprehend option Greeks, intimately understanding them is not option, it is a requirement, if one chooses to trade options.

i can share with you that many, including me, started with simply buying Call or Put options. i have not known anyone who had not had their account either completely wiped out or suffer huge losses as a result. unfortunately, this may be the only true way to learn option trading. a "tuition" fee is required.

having a solid theoretical knowledge of option is merely a pre-requisite to option trading. actually engaging in option trading is the next required step. only with sufficient practical experiences will one eventually become aware of where the trading edge is. unfortunately, such experiences can only be achieved through time and stoic practice.

in my opinion, option trading is plenty mathematics and some art... the Greeks are pieces of a puzzle...they are the trees that form the forest... to not know Greeks and trade options, is driving blindfolded, awaiting for a tragic ending to happen....(read : NEVER buy Asian Warrants no matter how tempting they are)

therefore, it is very important for option traders to begin by trading very small option sizes... by that, i mean ONE contract...with losses and profits as little as $100 or less per month. this does not sound like a very interesting endeavour, because it isn't. it is purchasing experience.

sadly, due to the leveraged nature of options, I mistook option trading to be big ticket trading. for example, i used to think that it is wise to Long Citibank Dec09 $5 Call (C now trading at $4.20) and pay 4 cents for it... One contract size cost me $4, 100 contracts = $400. 100 contracts = 100x100 or 10,000 shares. Imagine this: should C trade at $6 by 3rd Fri of Dec, my $400 of investment will reap $9,600 of profits... this is an extremely mouth watering proposition...except that in most times, i lost those $400...time and again... i clearly missed the forest for the trees..and i still do from time to time...

in option trading, i coin one of such sayings : "the foolishly uneducated treads where wise men will siam instinctively". i choose these harsh words to compliment the reality of option trading. only the best equipped option traders survive in the long haul; those who can instinctively explain their option positions like fish take to water...i am far from that level...if i was, i would be writing you from my personal island with one hand holding up a vodka lime and the other cleaning my ear wax

the sooner that option traders learn that it is usually a losing proposition to simply BUY an option, both Calls and Puts, the better option traders they become....most professional option traders do NOT simply buy plain vanilla options. they trade spreads of some sort. they do so, because they paid their tuition fees already...and graduated knowing immaculately option Greeks....

so, dont be discouraged...if you have a passion in trading options, like me and a few others here, you will be handsomely rewarded in time...others can laugh...but as you say.... this is a faceless forum...who cares

it will be good to hear your thoughts further on this topic...of cos, if others so give me "face" and participate in this discussion, all the merrier....

[kennynah]

Short Call vs Short Put

Currently, Visa (V) is trading at $80 and Implied Volatility is at ~26.6%

Intuitively, 80 Call and 80 Put must have the exact Greeks. In reality, there's a very slight difference in Delta of these ATM Call and ATM Put. But for this specific discussion, we will assume these ATM options are exactly at 0.50 delta.

Supposing you are directionally indifferent :

a) You think V will go higher
b) You think V will go lower

to rephrase, you think V will move away from $80 more so than it remaining closely pegged at ~ $80.

Scenario a)
If you believe V will go higher, you can choose to Long V 80 Call or Short V 80 Put. Let's assume you choose to Short V 80 Put.

Scenario b)
If you believe V will go lower, you can choose to Long V 80 Put or Short V 80 Call. Let's assume you choose to Short V 80 Call.

These are the Greeks of these 2 options :

Short V 80 Call (Delta : - 0.50, Gamma : - 0.07, Theta : +0.04 and Vega : - 0.09)
Short V 80 Put (Delta : +0.50, Gamma : - 0.07, Theta : +0.04 and Vega : -0.09)

Quiz :

Supposing V has an equal chance of moving up or down, which of the 2 options would you choose to establish and why? or are you indifferent and if so, why?

[teachme]

Hi Kennynah,

Thank you very much for taking the time to write the long reply at 0234hrs. I am most grateful. Nothing is more consoling to a loser than to hear that there are other losers and that it is normal to start off as a loser.

Actually, it's really not that painful to me because I have been there, done that with stocks. Kind of numb now. I have no beginners' luck but I am experienced to know that when a beginner makes money the first time, it is a curse and not a blessing. One is likely to become falsely over-confident, learn the wrong things and do the wrong things until he is humbled by the market.

It is generous of you to share your knowledge with us after making the transition from a loser to a winner.

[iam802]

These are the Greeks of these 2 options :

Short V 80 Call (Delta : - 0.50, Gamma : - 0.07, Theta : +0.04 and Vega : - 0.09)
Short V 80 Put (Delta : +0.50, Gamma : - 0.07, Theta : +0.04 and Vega : -0.09)

Quiz :

Supposing V has an equal chance of moving up or down, which of the 2 options would you choose to establish and why? or are you indifferent and if so, why?

Can sell both or not?

Am I correct to say that the Greeks (specifically Delta) suggest that price of option will go up/down by the same amount whichever way the stock price goes?

If that's the case, can we not just sell both, and just earn some petty cash from Theta?

[kennynah]

yes sir ! let me first rephrase the quiz:

Supposing V has an equal chance of moving up or down,

a) which of the 2 options would you choose to establish and why?
b) you are indifferent as to which option to choose why?
c) establish both and why?

[kennynah]

Am I correct to say that the Greeks (specifically Delta) suggest that price of option will go up/down by the same amount whichever way the stock price goes?

you are right... in this example, if V moves up or down by $1, the option values of the 80 Call and Put will increase or decrease by ~$0.50 ($1 x 0.5) since their deltas are 0.50

If that's the case, can we not just sell both, and just earn some petty cash from Theta?

this means you choose c) establish both Short 80 Call and Short 80 Put.

this is similar to selling a straddle. a Long straddle is Long Call and Long Put of the same strike of the same underlying which expire at the same month. if you recall my earlier description, it was mentioned that you are expecting V to not stay close to $80 but in fact expect V to move away from $80, just that you are not directional bias; ie, you think it could move up or down.

if this is the case, Selling a straddle may not be such a great idea, although, if V does not move sufficiently, this strategy could still be a profitable one. that is, as long as V's price movement stays within the breakeven points.

but let's nonetheless discuss this position from the Greek's perspective...

Short V 80 Call (Delta : - 0.50, Gamma : - 0.07, Theta : +0.04 and Vega : - 0.09)
Short V 80 Put (Delta : +0.50, Gamma : - 0.07, Theta : +0.04 and Vega : -0.09)

Short 80 Call (A) + Short 80 Put (B)
Delta of A + Delta of B = - 0.5 + 0.5 = 0
Gamma of A + Gamma of B = -0.07 + -0.07 = -0.14
Theta of A + Theta of B = +0.04 + 0.04 = +0.08
Vega A + Vega B = -0.09 + -0.09 = -0.18

in summary, the new Greeks profile for this option position is as such (Delta= 0, Gamma= -0.14, Theta= +0.08, Vega= -0.18)

Delta
what has happened is that with a 0 delta, this position becomes very insensitive to V's price movement. whether V moves up or dow, the option value does not change. this position best reflects a trader's intention for V to be stagnant. if the trader is expecting V to move away from $80, then the Delta of this position is not showing that desire.

Gamma
Gamma at -0.14 means that if V rises by $1 dollar, the overall position's Delta will become -0.14 {0+ (-0.14)} and if V drops by $1, the new Delta will be +0.14 {0 - (-0.14)}. these are not desired effects.
what you want is when V rises in value, the option's Delta must gain + delta and not become -ve delta. remember when you Long a Call, it is +ve delta and you want this +ve delta to get to +1.00 delta, which will happen when the underlying rises so much that it makes your Long Call get very deep In-The-Money... but if underlying rises in value, yet the Delta gets smaller or more negative, this option will defeat itself into a losing option.

Theta
Theta is doubled as a result of selling this straddle. very good indeed. with every passing day, this new position yields $8 (100 x 0.08) of premium into the account.

Vega
Vega is the amount of change to the option value per 1% increase or decrease in Implied Volatility of the options. if after establishing this short straddle, IV rises by 1%, this new position will lose $18 (100 x $1 x -0.18) and gains $18 if IV drops by 1% (100 x -$1 x -0.18). but IV rise and falls depending on several factors; such as the implied demand or lack of for the options, earnings news, M&A activities, new product launch, etc...
so, does it mean, it is better to be Short Vega (hope that IV will fall) or Long Vega. there is no right or wrong answer here. this is where the "art" of trading options come in.... if one believes that IV will drop off, then, logically, one will choose to Short Vega (which means, open Short option positions) and conversely, if one is expecting a increase in IV, then Long option position (which yields Long Vegas) maybe a considering factor.
yet there is one characteristic about underlying price movement that is intricately tied to IV. there is an inverse relationship. recall when SPX index falls, VIX rises and when SPX rises, VIX falls. similarly, if V's price drop off sharply and quickly, IV of V's options will explode upwards. now, envisage this scenario, V's price drop suddenly and intensely, you should be happy with that Short 80 Call. but in reality, even though directionally correct (Short Call represents non-bullishness outlook). such Short 80 Call can generate significant losses due to -0.09 vegas (Short 80 Call has a -0.09 Vega)
With Short 80 Put, you want V to rise in price and if it actually does, IV of V's options will likely decrease. A Short 80 Put has a -ve Vega which benefits when IV is lower... double winner here...

Hence between a Short Call or a Short Put, all things equal, I prefer a Short Put position.