Directional Trading With Options Pt2

Part 1 HERE.

In part one of this article, I stated that IF long option buys have any chance of outperforming straight out stock trading, it is the the "swing trading" time frame or momentum plays, generally moves that last 3 - 20 trading days. This is my opinion based on my experience and is not to say that one cannot be successful in other time frames, but let's just say my goal in option trading is outperforming stock trading over the long term; In other time frames, I doubt that the additional contest risk (extra brokerage and bid ask/spread in the notionally larger position size) and theta risk can be overcome by the advantages of gamma over the long term.

I m quite happy to stand to be corrected on this and I haven't done a scholarly thesis on this, but this matches the consensus of many other experienced option traders.

Firstly, lets look at the advantages and disadvantages of options versus stocks as I see it, always working with the assumption that an equal number of deltas is used, as described in Part 1

Complexity
Stocks have the advantage of being very simple to trade. You buy x number of stocks and that is the number of deltas you have, you can calculate the exact profit or loss that is possible from a given move. For example if you want to acquire 500 deltas of x stock, you simply buy 500 shares, if your stock goes up $1 you have made $500, if your stock goes down $1, you lose $500 - easy.

However to acquire 500 deltas in x's options, some qualitative decisions must first be made. Obviously those deltas are positive so we are looking at calls, but am I going ITM, ATM, OTM? What delta is the option I want to buy - and why? If the delta of the option is .33 we're going to need 15 contracts to get our 500 deltas. Fine, but what expiry? How far out to we want to buy - and why?

How will these decisions affect the outcome of the trade.

Stop Loss
There is an advantage in a long option position that the absolute maximum risk is known, that is the cost of the options. Stock traders will protest that a stop loss order can be placed on a stock position, however that does not protect the trader in the event of a large gap. If the stock gaps down 50% overnight, there is no stop loss in the world that will save you. In addition, once the stop loss order is triggered, you are out of the trade; and how often have you been stopped out only to see the stock immediately bounce higher?

Although the maximum loss of the option position may or may not equate to the calculated loss of a stopped out stock position, a maximum loss on the option position does not necessitate the exit of the trade. If that stock bounces back hard, you may still be in the money.

Gamma
Another advantage for the long option trader is gamma. This is the Greek that measures the change in delta as the stock price moves. If you are long the above calls, all things being equal, the position will increase in deltas as the stock goes up. So if that puppy is going in your favour, you have some automatic pyramiding of the position, and the higher it goes, the longer you get.

Likewise, if the position goes against you, deltas will decrease getting you less and less long as the stock moves down. The stock position never changes its delta however.

This is good news, the more gamma you have, the more accentuated this affect. There is a flip side to gamma though, which is...

Theta
Countering the positive effect of gamma, is theta (or time decay). Every day that you are in a long option position, you are losing time value on your option. Actually it is more complicated than that; the time value will vary in relation to the option's moneyness and volatility, but as a general principle it is true, an option devalues as time goes by.

Theta has a direct relationship to gamma, so the more gamma you have, so too the more theta you will have.

This is the prime reason I believe swing trading/momentum plays are the spot where long options may have an advantage over stocks; providing one makes intelligent choices regarding strike and expiry. You can acquire sufficient gamma to give you a real boost if you get on a strong move, yet not suffering to any great extent from the effects of theta.

Vega
Vega measures the effect of changes in volatility on the price of the option. Stocks don't have vega, so not a consideration. Whether vega is an advantage or disadvantage to a long option position is... well, it can be either and is not something to be ignored.

If you punt on some calls at what you think is the bottom of a big swoon at very high IVs, you will suffer some degree of premium sag if it starts moving your way, particularly if you buy OTM options and your position gets toward being at the money. You were right and you may be in profit, but it will be like having left the handbrake on.

It is possible to be right on the direction and still lose.

On the other hand, volatility tends to increase on down moves. Buying puts at low IVs can be spectacularly profitable if you catch a high volatility down move, because of vega.

These Greeks are all something to be considered when selecting strikes and expiries, or even whether to select a long option at all in a given situation, which goes back to the first point - Complexity.

These points I have only really touched on and there are deeper considerations to these Greeks, such as when and where their effect is greatest.

Part Three coming soon.