Using the option greeks to trade [Archive]

wayneL

9th-June-2005, 12:13 AM

.....following on from the other thread http://www.aussiestockforums.com/forums/showthread.php?t=1366&page=1
and Dutchies question.....

Option greeks are all very acedemic an' all, but few option traders actually use them to trade options!

Why is that? Well one reason is that they are so bloody difficult to understand, and in my opinion, are poorly explained by options authors. This is not the authors fault as they are usually have very mathematical brains and the way they view, and expain the greeks flies over the heads of us mere mortals.

Hopefully, i won't have increased confusion with my explanations LOL

Another reason is than they are sometimes *completey ignored by the seminar industry...are at best, quickly brushed over.

So we mortals start our option trading from behind the eight ball and get worked over by the smarties. ( If you haven't yet, you will. Record low IV's have made it easy to be an option buyer...wait til IV's start bouncing around a bit :) ) Let me be the first to admit that I started off knowing SFA as well. It was from being defeated by MM's that made me go and learn some more.

So here are the greeks (plus extra considerations) that I use to trade.

implied volatility
delta
gamma
theta
vega
implied volatility skew (thanks for the heads up Possie )

There is one other, Rho, that won't affect us in the current interest rate environment.

I'll work through how to use these in trading as I have time/motivation.

dutchie

9th-June-2005, 07:55 AM

Great Wayne - looking forward to your explanations and examples.
I agree that for beginners the Greeks are ignored as they are too hard to understand as far as their affect on an option trade is concerned.

DTM

10th-June-2005, 04:15 PM

Look forward to your posts Wayne.

Just out of interest, here's a link giving insight to a day in the life of a market maker.

http://www.derivativesstrategy.com/magazine/archive/2000/0700fea1.asp

It's confusing as it is so can't wait for Waynes explanations.

tigeroz84

1st-June-2006, 10:23 PM

Hi Wayne, do u still have the time/motivation to explain the greeks. Please do :)

BSD

1st-June-2006, 10:41 PM

Record low IV's have made it easy to be an option buyer...wait til IV's start bouncing around a bit :) )

I would say this lesson would be getting learnt across the board at the moment! Nothing worse than being right and wrong at the same time.

Buyers of vol would be enjoying this market - for the first time in some time.

Do you know many private punters that specifically trade vol though?

wayneL

1st-June-2006, 11:26 PM

Do you know many private punters that specifically trade vol though?

There wouldn't be a lot. But that's because most people are "educated" by "educators" who studiously avoid the subject.... or worse, actively discourage their students even considering it, along with greeks :banghead:

In reality, whether they realize it or not, they are trading volatility.

mit

2nd-June-2006, 02:18 PM

wayneL

2nd-June-2006, 05:23 PM

I'm curious then. If the educators ignore teaching the greeks, I can't understand why you wouldn't just trade CFDs because you'll get bitten pretty badly using options solely as a leveraging tool.

MIT

Mit,

Options sound much more mysterious and sexy, so they can charge more... and with CFD,s you can't promote Magic Moo Cows and Share Renting and other such silliness.

You wouldn't believe some of the BS that some option "educators" spew forth.

Cheers

wayneL

2nd-June-2006, 05:51 PM

You wouldn't believe some of the BS that some option "educators" spew forth.

Cheers

Some examples regarding covered calls (AKA magic freakin' moo cow & Share Renting, FFS)... Direct quotes:

1/Since the short call is covered by the stock,this strategy has no downside risk. The only upside risk is that you give up the price appreciation above the strike price of the call; however, the call premium paid at the outset may compensate for this risk....

2/Complicated and speculative? NOT AT ALL. Writing covered calls is one of the most conservative investment strategies.... When you buy a stock and sell a covered call against it, you know exactly what the monthly return on that investment will be before you actually buy the stock. The cash shows up in your account the next morning, for you to withdraw or reinvest according to your investment needs and objectives.

3/Writing covered calls is perhaps the safest of all option strategies and possesses minimal risk.

4/ While the covered call writer has no risk of losing huge amounts of money, there is an attendant risk of missing out on large gains.

FFS!!!!! Absolute BS! :banghead:

sails

2nd-June-2006, 08:04 PM

Yep - shout it from the rooftops, Wayne!

One analogy they use that is only partly true is that covered calls is like "renting" shares. However, when one owns a rental property, receiving rent does not cap capital growth - but sold calls can do just that and, under certain circumstances, can actually lock in a loss - but they don't tell you that... :rolleyes:

Certainly not for novices imo and like any options position, one needs to know how to manage it properly - just my :2twocents

professor_frink

2nd-June-2006, 10:03 PM

I was given a book last christmas that is choc a block full of this kind of rubbish- won't mention the book but here are some comments he makes-
When describing how a put option(he calls it buying insurance) works-
" say you buy an option for 30c when the stock is at $16 because you think the price will fall. Say it falls to $13, then that insurance will be worth $3.30. In other words you have outlayed 30c can now sell that insurance for $3.30. That's not 10%,or even 100%, but in excess of 1000% on your money and that could occur in a few days or a few weeks."

I love the simplistic way this is described, no mention of selecting an appropriate option to trade, no mention of greeks or volitility. No mention of a strategy to try and find a stock that he thinks will move. Just buy an option- it's just that easy! I loved the way he casually mentioned a $16 stock moving down to $13 in a matter of days or weeks, like it happens all the time. A near on 20% fall on a share that you can leverage into an options trade to make a 1000% return is easy folks, didn't you know?

The section on share renting came after this bit, but alas, I didn't make it that far!

wayneL

2nd-June-2006, 11:04 PM

professor_frink

3rd-June-2006, 07:13 AM

good guess wayne. It's a shame his strategies were so dodgy, because the early part of that book showed a little bit of promise. Teaching people the first parts of the book that deal with goal setting, paying off debts, becoming financially intelligent, etc are all good ideas. I've got a couple of friends that could benefit from that part of the book, but I can't bring myself to recommend it to them because the strategies at the end of the book are so bad!

hissho

4th-June-2006, 09:05 PM

Hi Wayne

I'd like to hear how you use the Greeks to trade, with some examples and strategy analysis. Quite a lot of ppl are looking forward to it as well.

thanks a lot
hissho

wayneL

5th-June-2006, 02:58 AM

Hi Wayne

I'd like to hear how you use the Greeks to trade, with some examples and strategy analysis. Quite a lot of ppl are looking forward to it as well.

thanks a lot
hissho

Am doing some work on this

But briefly, There are six greeks as far as the retail trader is concerned.

Delta
Gamma
Sigma (volatility)
Vega
Theta
Rho

When you take on an options position you are actually taking six positions, represented by the above greek(?) letters (Vega is not a greek letter)

Most traders only consider Delta (Direction) and/ or Theta (time decay) and disregard the other greeks. This can be costly.

To describe all the consideration of trading with greeks would require a book sized tome to describe and must be done on a strategy by strategy, position by position basis. There are numerous hints and references in posts by myself, Sails, Magdoran and others throughout this forum. Keep your eyes skinned for references to greeks. There was a paper trade posted here on OSH somewhere (use the search function) that was an attempt to trade primarily Vega, with some Gamma as well. Although I lost track of it when returning to the US market it did turn out quite well in the end.

Cheers

RichKid

5th-June-2006, 10:03 AM

Am doing some work on this

But briefly, There are six greeks as far as the retail trader is concerned.

Delta
Gamma
Sigma (volatility)
Vega
Theta
Rho

When you take on an options position you are actually taking six positions, represented by the above greek(?) letters (Vega is not a greek letter)

Most traders only consider Delta (Direction) and/ or Theta (time decay) and disregard the other greeks. This can be costly.

To describe all the consideration of trading with greeks would require a book sized tome to describe and must be done on a strategy by strategy, position by position basis. There are numerous hints and references in posts by myself, Sails, Magdoran and others throughout this forum. Keep your eyes skinned for references to greeks. There was a paper trade posted here on OSH somewhere (use the search function) that was an attempt to trade primarily Vega, with some Gamma as well. Although I lost track of it when returning to the US market it did turn out quite well in the end.

Cheers

Yep, there certainly is a lot posted already in this forum, by Wayne in particular, I like to re-read the material from time to time, it certainly helps!

Magdoran

5th-June-2006, 02:25 PM

Hello All,

Salutations to Wayne for making the effort here to address what is probably the most involved area of options trading – understanding the nature and effect of the “Greeks”.

Since there are so many variables involved, perhaps it would be worthwhile to narrow down some areas of interest into modules. The options mentoring thread is effectively addressing the definitions for the Greek components, as well as addressing some strategies, hence it’s a great resource for information.

Why don’t some of the people who are interested in asking questions outline what they are looking for? Key notions are what kind of trader/investor are you? Here are some attributes to consider:

• Time Frame - Long term, swing/position trader, day trader?
• Risk tolerance – aggressive, conservative, moderate, etc?
• Analysis approach – fundamental, technical, other?
• Investment approach – growth, income, speculation, portfolio protection/diversification/hedging?
• Available time – how much effort will you commit?
• Tools – software/connection/hardware, texts, etc?
• Knowledge and experience – what do you need to know?

Why this is important is that there are so many elements to derivatives. Your requirements are unique. What the more experienced players can do is to relate their experiences, and point you towards knowledge that may be relevant to your situation, but requires a degree of application and study by people who are learning.

The area is so vast, it is unlikely anyone will know all the aspects that are relevant to you, but at least you can glean enough to form a foundation for developing key knowledge and skills.

So, let’s see some posts covering areas like hypothetical trade/investment scenarios, options questions, and trading/investing profiles. This would help to address what people really want to know… how does that sound?

Regards

Magdoran

hissho

5th-June-2006, 04:36 PM

Why don’t some of the people who are interested in asking questions outline what they are looking for? Key notions are what kind of trader/investor are you? Here are some attributes to consider:

• Time Frame - Long term, swing/position trader, day trader?
• Risk tolerance – aggressive, conservative, moderate, etc?
• Analysis approach – fundamental, technical, other?
• Investment approach – growth, income, speculation, portfolio protection/diversification/hedging?
• Available time – how much effort will you commit?
• Tools – software/connection/hardware, texts, etc?
• Knowledge and experience – what do you need to know?

Magdoran

Thanks Mag!
time frame--->days to weeks; but i don't wanna spend a whole day sitting in front of my computer; one hour for opening and one hour closing would be fantastic
risk tolerance--->moderate to aggressive
analysis approach--->70% fundamental and 30% technical
investment approach--->income
available time--->as many as required; the goal is to spend 1 hour when the market opens and 1 hour closes so that i can do other stuff during the rest of the day otherwise i would be finding myself another job...
tools--->Optus broadband; bought a few books; still deciding which software i need to purchase...
knowledge and experience--->not much; bull put spread is not the HolyGRail which i found out after doing 3 trades; wasted $$$ on expensive course etc. now decided to do whatever it takes to learn the real stuff.

I'd like to see an example of how a trade is done: what are the steps you take to find potential profitable trades, filter out and decide the trade you are most comfortable with---that is, i'd like to know the whole process(briefly). btw i'll share all the lessons i've learnt so far in another post. Be prepared to be shocked what a terrible trader was like.

again thanks a bunch for the time and help
hissho

Magdoran

5th-June-2006, 05:33 PM

Warning!!!: Options may or may not be suitable for different investment goals, and individuals may wish to seek suitable professional advice for more information.

Using options effectively is an involved process, and any of the examples used here may or may not yield the returns published in real market conditions – it is possible for substantial losses to be realised trading leveraged instruments, hence traders/investors should take this into account before investing.

Also, please consult the ASX website for documentation/courses on Derivatives: http://www.asx.com.au/index.htm

Hello hissho,

If you wouldn’t mind, could you give me a little more detail on your investment approaches please?

Experience/Knowledge:
• What were your previous strategies you used in the market?
• What was the time frame you held the above investments?
• Can you outline how you traded the bull puts?
• What were the key take away ideas from the course you attended?

Analysis:
• What kind of fundamental analysis do you use?
• What is your entry and exit criterion?
• Please describe the technical approach you use and how you incorporate this with your fundamental approach.

Risk:
How much are you prepared to lose on each trade (what is the maximum loss you can tolerate?)? Are you prepared to lose?:
• 50%?
• 100%?
• 20%?
• Another amount?

Tools:
How much funds are you willing to allocate to:
• Purchasing options software?
• Ongoing data costs?
• Further training?
• Text books?

Investment Goals:
• By income do you mean gaining profits from using short term directional option strategies, or are you aiming for longer term credit spreads for instance?
• Have you considered dividend strategies with endowment/instalment warrants?
• Do you have an existing portfolio – please expand if so (options for hedging?)
• How long do you want to be in the option position for?
• Will you need your trading capital for use in other areas?
• Are you aiming to make a sole living from trading?

Using Options strategies:
• Do you have a preference for directional or non directional approaches?
• What kind of returns are you looking for over what time period?
• What options texts do you have?
• Do you have any trading/investing software? If so, what is it?

Gee, this list has grown, hasn’t it? But please try to give me some information to allow me to formulate some approaches on several different levels which you may want to look at…

Regards

Magdoran

Magdoran

5th-June-2006, 06:20 PM

Hi All,

Sorry, shouldn't have asked such personal questions in a public forum... but working on a scenario for posting soon...

Magdoran

wayneL

5th-June-2006, 07:04 PM

Risk:
How much are you prepared to lose on each trade (what is the maximum loss you can tolerate?)? Are you prepared to lose?:
• 50%?
• 100%?
• 20%?
• Another amount?

Hi folks,

I haven't got a lot of time today, but I just wanted to suggest an alternative view to risk.

The percentages Mag has used above, indicate the amount of risk of the actual capital used in the trade. E.g if you paid $1000 to go long some calls, how much of that $1000 are you prepared to lose?

I look at things in a completely different way. I don't give a toss how much premium I lose as a percentage of itself. I consider a 100% loss of premium as actual risk. There are many circumstances where you will not be able to avoid 100% loss of capital at risk, just check out the screenshot below.

This also illustrates quite satifactorily, option trading commandment #1 "Thought shalt cover thine @rse". Che Guevara stated it succinctly in his own field of endeavour. "The first duty of the guerilla fighter is survival"

Therefore, what I do care very much about is what % of my total capital that potential loss repesents. If that $1000 loss was from a bank of $2000, then that's catastrophic. You've just effectively blown yourself up. If it's from a bank of $2,000,000 then it's only lunch money. In the situation depicted below, I would ensure that this event is merely of passing interest, a mere war story where other folks blew themselves up. Maximum loss for me is a very small % of my capital.

Standard fixed fractional money management folks.

Magdoran

5th-June-2006, 07:21 PM

Just a quick comment:

Wayne makes a good point about the broader concept of potential loss to your overall trading/investing capital, and in the broader trading sense is a vital concept (good points Wayne, thanks).

What I was actually doing was something a little different however, and the question I raised about risk had a specific purpose: Under the new financial regime under the auspices of ASIC, determining the actual level of risk tolerance for the individual is critical (and a requirement for Financial advisors).

The question was designed to elicit a second response to the risk tolerance question in an effort to confirm or modify the response given (moderate to aggressive), which materially effects a whole range of approaches to derivative strategies, and will help me to set up a realistic scenario to best illustrate some points to benefit hissho, and anyone else in similar circumstances.

This method of verification is in part based on the approaches required to attain PS 146 certification (I have PS 146 certification in derivatives and securities), hence my interest was to tailor the scenario in a generic format, but in a way that would benefit hissho to the best of my ability, but also not to contravene ASIC requirements.

Hope this makes sense.

Regards

Magdoran

hissho

7th-June-2006, 09:22 AM

fantastic doran and wayne!

since this thread is about "how to use greeks to trade", i'd like to hear how you would approach it if you held the view that asx index has another 200-250 points to go down...i'm not saying i'll ask the question here and follow any advice to actually do the trade, just for education purposes.

so you got a view, how would you approach it? what would be your first step? find out historical and implied volatility about XJO? and then? what strategies would come up into your mind? buying puts would already be too expensive if IV is high... how would you compare those strategies coming to ur mind and finally decide to take one that you think is most appropriate?

again let me stress this: not seeking trade advice here and then simply "copy and paste", just to learn the way professional traders think and make decisions...

your comments would be greatly appreciated
hissho

Magdoran

17th-June-2006, 02:01 PM

Hello All,

I had intended to put up some real time examples to illustrate how to use the “Greeks: to trade, but in the current market conditions, I am reluctant to demonstrate short term bearish trades which are highly risky, and require both specialist knowledge in derivatives, as well as understanding how markets trend in order to forecast accurately enough in time and price to determine entry and exit points with precision.

I judge this dangerous for newer players to start with as it takes years to develop the requisite skills to do this, as well as it being inherently risky, and may give newbie’s the impression you can just cash in 1000% gains regularly, rather than recognise that these moves are the exceptions you look for if you are a directional position trader with the experience to achieve this kind of result in a bearish drive.

The problem with trying to day trade strong bearish moves is that the options market though opening at 10:00 AM doesn’t require the market maker to make a market for about 30 minutes, and if they do trade with you when there isn’t someone else to take the opposite side of the transaction (i.e. interest is low in the strike you’re looking at, at the time you want to trade, on the side of the bid and ask you want to enter). There are a host of hurdles like the width of the spread, and the artificial moving around of volatility.

You really need a major movement in the underlying to do well out of these moves for intra day players, and I’ve found position trading with specific time and price objectives to work the best combined with exiting partial positions to lock in profit (see the thread on trading partial positions). But this is of course up to the individual, and their preference and capability.

I also don’t want to tip my hand with what I’m up to while the market is trading like this by giving out key information that may be detrimental to my positions, so please understand, under normal conditions it wouldn’t matter so much. So, with these combined factors I haven’t published on this thread, and am waiting for a reasonable example. Please also understand that there are a myriad of viable approaches, and that the freedom to use derivatives comes at a cost of complexity and an over abundance of choices.

Regards,

Magdoran

wayneL

17th-June-2006, 05:11 PM

Hello All,

I had intended to put up some real time examples to illustrate how to use the “Greeks: to trade, but in the current market conditions, I am reluctant to demonstrate short term bearish trades which are highly risky, and require both specialist knowledge in derivatives, as well as understanding how markets trend in order to forecast accurately enough in time and price to determine entry and exit points with precision.

I judge this dangerous for newer players to start with as it takes years to develop the requisite skills to do this, as well as it being inherently risky, and may give newbie’s the impression you can just cash in 1000% gains regularly, rather than recognise that these moves are the exceptions you look for if you are a directional position trader with the experience to achieve this kind of result in a bearish drive.

Great comments there. This something I have a monumental challenge with in regards to most seminar promoters... and why most noobs get crunched, combining unrealistic expectations with a (seemingly intentional) omission of crucial knowledge.

The problem with trying to day trade strong bearish moves is that the options market though opening at 10:00 AM doesn’t require the market maker to make a market for about 30 minutes, and if they do trade with you when there isn’t someone else to take the opposite side of the transaction (i.e. interest is low in the strike you’re looking at, at the time you want to trade, on the side of the bid and ask you want to enter). There are a host of hurdles like the width of the spread, and the artificial moving around of volatility.

You really need a major movement in the underlying to do well out of these moves for intra day players, and I’ve found position trading with specific time and price objectives to work the best combined with exiting partial positions to lock in profit (see the thread on trading partial positions). But this is of course up to the individual, and their preference and capability.

Strongly agree. Day traders should avoid options in most cases.

Re 10:00AM opening: YO! Another advantage of the US market. It opens along with stocks and traded right through lunch as well. :D

Please also understand that there are a myriad of viable approaches, and that the freedom to use derivatives comes at a cost of complexity and an over abundance of choices.

Yes. A book sized endeavour here.

Cheers

NettAssets

17th-June-2006, 05:40 PM

Re 10:00AM opening: YO! Another advantage of the US market. It opens along with stocks and traded right through lunch as well. :D

Cheers

Seems like there are some changes in the wind for us here as well. Lunchtime trading and only 10 mins for the MM's to get their markets up if I have understood right

wayneL

17th-June-2006, 05:48 PM

Seems like there are some changes in the wind for us here as well. Lunchtime trading and only 10 mins for the MM's to get their markets up if I have understood right

Not before time NA, the current situation is quite ridiculous IMO.

swingstar

17th-June-2006, 05:48 PM

Great comments there. This something I have a monumental challenge with in regards to most seminar promoters... and why most noobs get crunched, combining unrealistic expectations with a (seemingly intentional) omission of crucial knowledge.

Is this also true for buying at the money? I've been trading for a year and haven't had an ATM option go against the underlying price.

I understand I should have a decent understanding of greeks, and it's next on my list of things to do, but so far ignorance hasn't affected me that I'm aware of. That is, just swing trading and buying at the money.

NettAssets

17th-June-2006, 05:54 PM

Had one recently on Santos that worked in my favour
Bought the may ATM call and sold 1.5 above and they both made money! whether this is just something that is actually not real I don't know.
I only gave a price I was prepared to pay and get for the spreads and the individual prices where quite different from what I expected

swingstar

17th-June-2006, 06:16 PM

I've made about 100 trades at the money and none have gone against the security. Some may have not moved as much as I would have thought, but then I only have basic understanding of how they're valued. All of those were bought within 4-8 weeks out from expiry.

wayneL

17th-June-2006, 06:54 PM

Here's an example of vega risk.

I haven't got the precise numbers but working off IV levels:

Earlier in the week ATM sept calls on S&P500 futures were worth around 46 points with IV having had crept up to around 19%. IV has subsequently collapsed to around 13% yesterday and (presuming there ws no movement in the underlying) those calls are now only worth about 32 points.

This means the index could have rallied 28 points over the last three days, yet the value of your call is the same.

I was on the other side. When I saw IV @ 19% I was able to write and get decent premium WTFOTM for expirty in July... 100 pts OTM in fact. In three days vega has handed me a tidy profit and it would take a particularly nasty black swan for me to even consider any defensive tactics necessary.

Now think of the numpties that bought those OTM options. They are way behind the eight ball and their chance of a profit is probably around 1%.

Bear in mind these tactics IMO are only applicable with a degree of safety on indexes (which I have explained elsewhere). I would NOT do the same thing in stocks without hedging myself.

Cheers