Tuesday, December 22, 2009

Explaining Risks through Greeks


let's use SPY trading at $108.20 with 11 days to expiration....the following Greeks for a Long Nov 109-strike Call are :

Delta : +0.41
Gamma : +0.1
Theta : -0.06
Vega : +0.08


we move on to more specific Greek talk..

the above is a Bullish directional option position, which was established by paying a premium of ~$1.91 or $191 for 1 contract size.. this is evident from Delta, which is +ve 0.41.. this also represents the position's biggest risk..

Delta Risks
why is this +ve 0.41 delta, the biggest risk? for one primary reason; if SPY moves up or down 1point, this position gains or loses $41 (0.41 x 100)respectively. this is a 21.5% fluctuation in the P/L; a significant % by any measurement.

therefore, before anyone goes Buying single directional options, whether Long Calls or Long Puts, the trader MUST understand Delta risks... which is most prevalent for Long Calls and Puts.

Gamma Risks

a +ve gamma is always associated with any Long options. remember, +ve gamma has nothing to do with directional bias. this means, one can Long Call or Long Put, such positions will always yield a +ve gamma. as long as you BUY an option, you will be +ve gamma; and conversely, as soon as you are Short(sell or write) an option, you will be -ve gamma.

gamma is best explained vis-a-vis delta. they are a pair of Siamese twins...because delta of an option position changes ONLY because gamma changes it. if gamma is 0(zero), no amount of movement of the underlying will change the delta value of that option !!!

in this example above, this Long SPY 109 Call assumes a +ve 0.1 gamma risk. how so? recall that gamma changes delta. gamma either makes a delta bigger or smaller. in this example, if SPY moves up 1 point, this Long 109 Call delta becomes +ve 0.51 (0.41 + 0.1) and if SPY drops by 1 point, the same Call option value will drop by +0.31 (0.41 - 0.1). of cos, this is a simplified calculation, becos gamma itself changes as SPY moves about. but we will keep it simpler here.

hence, if SPY moves up by 1 point, gamma helps the 109Call value tremendously by pumping the delta value up by ~24%(from 0.41 to 0.51),making this an even greater delta risk play. similarly, if SPY drops by 1 point, the option value will drop by ~23%..

therefore, if you are very bullish and decide to purchase a Long Call option, you want a large enough +ve gamma, to help you increase your +ve delta. BUT you had better be right on your directional bias, because if you were wrong, a large +gamma can also quickly erode your +ve delta of your Long Call option position, making it less sensitive of subsequent upward price movement of the underlying.

this, in a gist, is what gamma risks is all about...

Theta Risks

Theta is defined as the Rate of "Decay" of any option's extrinsic premium.

A side note on option premium. All options value are composed of intrinsic and extrinsic values. For example, recall that this Long SPY Nov 109 Call is valued at $1.91, when SPY was trading at $108.20. This is an OTM Call. This $1.91, the value of this Call option, consists of $0 Intrinsic value and $1.91 of Extrinsic value.

All OTM options contain only extrinsic values. ONLY ITM options contain intrinsic values.

Thus, when you purchase this 11days to expiration Long SPY Nov 109 Call, and paid $1.91, all of this is "time" fee. This is "fair" because option is a leveraged instrument, allowing you to gain control of 100 SPY shares at a fraction of the cost of actually buying SPY shares. The tradeoff, is that you pay such extrinsic value, build into the SPY options. Option trading epitomizes the saying "There ain't never a free lunch in this world !!".

Theta affects ONLY the option extrinsic value, NEVER the intrinsic value. In this example, there is $191 worth of premium to be decayed.

So, as with the above example, with a -ve 0.06 Theta, with every passing day, this option decays by $6 (0.06 x 100). You would have noticed an anomaly by now. Given that this option has only 11 days to expiration, doesn't it mean that there is only $66 ( $6 x 11 days) of decay, but with an extrinsic value of $191. So how is this possible? This is possible, because Theta does not decay in a Linear fashion. In fact, the rate of decay (aka Theta) becomes larger as time to expiration nears. It accelerates very aggressively in the last days and last moments of the option's life !!!

A very important lesson about Theta is this...

Supposing you did purchase this Long SPY Nov 109 Call and paid $1.91 and on the final day of expiration, SPY settles at $110. One would imagine making a profit from this position. This cannot be further from the truth. In fact, if SPY had ended at $110 at expiration day, this position would make a loss. By how much?

Value of 109 Call option on expiration, with SPY trade close at $110, will have a value of exactly $1. That Long SPY Nov 109 Call can be exercised into 100 shares of SPY shares at $109 and immediately be sold off in the open market for $110, profiting $1. Of cos, this Call option will be valued at $1 exactly, no more, no less..."No free lunch mantra, remember"....

So, with this SPY Call worthy of $1, and yet you paid $1.91 for it 11 days ago...tell me, how could be be a profitable trade? It is a bigger-than-burger-king-big-whopper loss of 48% !!!

But wait...just when you think this is bad...I've got worse news...Supposing SPY on expiration day closed off at $109, that Long SPY Nov 109 Call would be worth $0 !!! All of that $191 paid for that Long Call option, miraculously vanished into thin air. Talk about frustration! You've got your market direction right, no doubt about that. You entered the trade when SPY was $108.20, and 11 days later, SPY did rise to $109, and yet, you lost 100% of your capital on this trade. Ain't this a sucker trade !! Bitch it all on -ve Theta.

Now, I believe Theta has your attention and respect (sing that song...R-E-S-P-E-C-T by Donna Summers) .......this is what Theta risks is all about.... in this case, contrary to popular saying, time is not money...instead, time is your foe, when you are -ve Theta...

Bull Call Spreads with Positive Theta

Bull Call Spread

We know that a Bull Call spread is a bullish position, with limited profit potential and losses. It this sense, credit Call spreads are limited risks positions...

A Bull Call spread consists of Long Call and Short Call of a higher Strike price.

Let's take AAPL as a case study....with AAPL price trading at ~$196

Some traders like to establish

A) Long 200 Call + Short 220 Call and pay $5.41 premium
vs
B) Long 180 Call + Short 200 Call and pay $15.38 premium

P/L for A)
Max Profit = $14.59 ( $20 - $5.41)
Max Losses = $5.41

P/L for B)
Max Profit = $4.62
Max Losses = $15.38

A) has a lot of profit potential and losses are much lesser, when compared to B). Moreover, it costs less to establish A) than B).

QUIZ :

Which of the 2 positions is a better trade, if indeed there's any difference, given the following Greeks:

GREEKS of A)
Delta +43
Gamma +1.5
Theta -7
Vega -11.6

GREEKS of B)
Delta +37
Gamma -1.7
Theta +4.9 >> most are mistaken that Bullish option positions will always yield -ve theta.. clearly not true
Vega - 11

Covered Call Variety

Covered Call

We all know that the term, Covered Call, implies a position consisting of Stocks and Short Call options...

example: 100 shares of AAPL (Apple) at $196.40 and 1 contract of Short AAPL Jan $210 Call (whose premium today stands at $2.15)...

The 2 primary reasons for having such a WRITE Buy are :

a) Income generation from the premium collected for selling the Short Call option
b) Cushioning price decline

this position roughly requires a capital outlay of $19,425 (100 x $196.40 - 100 x $2.15)...

Max Profits = $1575 (trust me here)
Max Losses = $19,425 (if AAPL bankrupts and price zooms to $0)


now...consider the following alternative :

naked 4 x Short AAPL Jan 195 Put ...whose premium is currently $350 per contract

this position requires margin of ~ $15,600 to be set aside

a) Max Profits = $1400 ( 300 x $3.50)
b) Max Losses = $78, 000 (400 x $195) >> (if AAPL bankrupts and price zooms to $0)


now, if AAPL does indeed collapse and stock value goes to $0... i guess, i would throw in the towel and admit, i am not cut out for this business... ie, this scenario is remote...not impossible...but very slim chance...

this said, look at the 2 trades... would you not say, they are about similar.... they both have limited profit potential and very large potential losses..


QUIZ :

so, why would anyone be interested to purchase Covered Call vs Naked Short Put, given that they 2 are synthetically similar (they are...trust me)....

assumption : NOT a dividend paying Stock...

Result of GS Trade

but alas...i didn't establish the above trade (refer to this link >> http://optionsstrategies.blogspot.com/2009/11/trading-options-on-goldman-sachs.html )....if i had, it would have been a winner...on both counts...

Long GS Dec09 165 Put and pay $5.60 >>>> GS did lose value to a low of ~$161 on 17Dec09
Short GS Dec09 170/175 Call and receive $1.14 >>> this option expired worthless on 18Dec09, thus I keep all of $1.14 premium

but this is only how it looks like on the surface....

QUIZ :

In reality, how much profit did I make if I held 100 shares GS and 1 contract of that Short Call spread until option expiration last Friday, 18Dec09?

Delta Neutral Discussion

Delta-Neutral Trading

Selling a Strangle, such as Short V 80Call and Short V 80Put in our example, results in 0 (zero) Delta. Recall, that value of options with a 0 Delta position will not be affected by underlying price movement.

Perhaps by relating options to stocks, Delta can be better explained...

Long 100 shares of V = 100 Deltas
1 contract of Long V 80 Call (this is ATM Call) = 100 x 0.5 = 50 Deltas (1 option contract = 100 shares)
=> 2 contracts of Long V 80 Call = 50 x 2 = 100 Deltas

Therefore, Long 100 shares of V = 2 contracts of Long V 80 Call

(sidetrack : 100shares of V @ $80 = $8000 of capital. 2 contracts of V 80 Call will cost only a few hundred. such is the leverage nature of options)

802 is correct to suggest that if we Short 80 Call/Put, yielding a 0 Delta, which means that however V price swings, we just milk the Theta dry (read : profit from premium decay)... this is the intention !!!

Although such Short Strangles have 0 Delta, it doesn't mean that this Delta will stay totally unchanged. Given sufficient movement in V's price, this Delta will become more +ve or -ve; the reason? Gamma. This old faithful Gamma is at -0.14

Delta-Neutral trading is the process of ensuring that the overall option position is immune to price swing in either direction. It aims to profit from either Theta or/and Vega movement....

I'll leave it as such for now...and open this for further discussion...

Saturday, November 28, 2009

Trading Options on Goldman Sachs?

GS - Goldman Sachs

As I looked at GS chart, I cant resist wanting to go bearish on this stock.



GS is currently trading at $164.16 and has a current Historical Volatility of ~33%.

Using options, I can construct a bearish play, like so :


Long GS Dec09 165 Put and pay $5.60
Short GS Dec09 170/175 Call and receive $1.14


This position will cost a trader $446 and require a margin of $386.

The maximum losses is $946
, if at option expiration, GS trades above $175; ie. GS goes past the Long 175Call option. If this happens, all of the premium paid, $446, for Long 165Put will be lost. The Short 170/175 Call spread will cost $500. Hence, the total damage = $946.

This position has unlimited profits
. Although it is enticing to add a "unlimited" profit potential position, the trader must have a reasonable chance of it actually happening. In this case, we need to know how much GS price needs to weaken in order to make enough profits to justify the potential max loss of $946 !

To be able to achieve ~$950 of profits, GS must trade at $151 in 20 days time. GS must drop by some 8% from its current ~$164 price tag. Is this reasonable expectation? Let's get scientific about it.




Take a look at GS Option chain appended below. It shows that 150Put has a -0.14 delta. Ignore the -ve polarity. This is telling us that there's roughly 14% chance of GS price settling at or below $151 at expiration. Restating, GS has ~86% of staying above $151 in 20 trading days. Delta is a trader's rough gauge of an option expiring In-The-Money.

A more scientific way is to actually calculate the de-annualized Implied Volatility. Right now, averaged ATM option is showing about 31% annual IV. To calculate the potential move of GS price in 20 days, do this :

square root (20/365) x 31% = +/- 7%

There's a 68% chance of GS price fluctuating 7% up or down within 20 days. This makes GS price having a 2/3 chance of trading between $152.60 and $175.65. Now, this position makes ~$950 if GS price trades at $151 at expiration day. This calculation suggests that this is outside the 2/3 chance; ie. this trader has only 1/3 chance of making $950 or more but yet has 2/3 chance of losing $946.

Now, it is apparent that the risk/reward is not so enticing anymore.

Thus, as much as this trader likes to establish a bearish position on GS using options, current option chains do not offer the trader any meaningful way of doing so. It would be wise to find another trade.

Formulating Option Trade by applyng GREEKS

TLT - iShares Trust Barclay's 20 Plus Yr Treasury


Remember that Option Trading is no more different than stock trading, in that one needs to first formulate an trade opinion, as part of an overall trading plan.



In this example, using TA, I see a possible bullish setup at this juncture. Obviously, one can include FA into consideration or use both TA and FA to decide if TLT will move up, down or sideways in the next 3 weeks.

As my trade opinion is that TLT will move higher than current price, I need to adopt appropriate Option Strategies that can offer an acceptable potential profits for some known associated risks of this position.

Note that Historical Volatility for TLT is now ~13%. It is at the low end of its HV. Option chain of Dec09 TLT also shows a similar Implied Volatility.



This is one possible setup employing ONE contract size :

Long TLT Dec 96 Call and pay a premium of $1.25 (known risk).

Short TLT Dec 96/94 Put and receive a premium of $0.67.


This entire position requires a capital outlay of $58 ($125 - $67) + commissions + $133 ($200 - $67) of margin requirement.

The maximum loss of this trade = $258 ($58 paid for this position + maximum loss of the $2 wide Short Put spread)

The maximum profit is unlimited !

GREEKS for this trade :

Delta = + 77.05
Gamma = + 11.45
Theta = - 1.40
Vega = + 7.09

Clearly, this is a +ve Delta setup, a Bullish position, which reflects the bullish opinion. If TLT moves up by $1, this position makes ~$77 and loses the same if TLT drops by $1. Of the remaining GREEKS, Gamma is the next most significant risk factor. It will fluctuate Delta more or less by ~15%; ie. quite quickly with TLT's price swings.
A short note on Implied Volatility. As TLT is now trading with HV of only 13%, TLT options are also relatively cheaper now than when TLT was at 36% volatility. Remember that option values are positively correlated to Implied Volatility. The lower the IV, the cheaper the option. It is unwise to buy options when IV is very high, such as those just before an earnings report.

The main reason that this delta is large is because of the choice of ITM 96 Call. Since TLT is currently at $96.40, this ITM 96Call has a delta of +0.54. The Short 96Put is also very near ATM and so yields another +0.47 deltas. Both these options combine to form ~ +1.00 delta.

You should realize now that Long 96Call + Short 96Put = a synthetic Long TLT stock !! You paid $58 capital to establish a position that almost mimics a Long TLT stock position, which otherwise would have cost $9,640 to buy the 100 shares.

This is the power of option leverage. But it is not free. There are trade offs.

a) this option expires in 20 days
b) $1 move in TLT yields ~$77 vs $100 if 100 shares of TLT was bought
c) this overall option position has a maximum risk of $258 ($200 + $58) vs maximum losses of $9640 if TLT stock price drops to $0. of cos, we dont expect this to happen. but even if TLT drops off $10, the losses would be $1000 if 100 TLT shares were purchased. in other words, the downside losses can be very damaging. but using this option position, the losses is capped at $258.

If you believe that TLT will move significantly to the upside within the next 3 weeks, then consider establishing this position, instead of outlaying $9640 to buy 100 shares of TLT when all you need is $258 to put on this option trade.