Options Trading / Gaining the Edge & VIX Curve Implications
Options Leverage has become increasingly popular over the past decade. In the past 30 months,
their popularity has risen significantly relative to the Underlying Instrument.
Increasingly so, Options tend to move Prices through the effects of Leverage.
This is why we see Stocks Split, it vastly reduces the Price of Entry and increases the Potential
for increased participation.
As in all Markets, Liquidity plays the most important Function.
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The Traders Edge is best capitalized through an understanding of the Derivatives/Options Greeks as
well as VIX timing (previously discussed and linked below).
I will thoroughly explain the relationships and provide direct correlations using Price in each example.
Simplicity will become self-evident after All the Variables are explained.
Directional Risk Management is the Traders Edge. It provides the Risk/Reward parameters in Options
Trading will make you a far better Options Trader.
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Options are a 1st Tier Derivative, ie. - their value is "derived" from an underlying asset. How this value
is derived depends upon a number of factors:
1. The 5 Greeks and their functions - Delta, Gamma, Theta, Vega & Rho.
With any Derivative - Dependent and Independent Variables define the Function.
Greek Dependent Variable Independent Variable
Delta Option price Value of Underlying Asset
Gamma Delta Value of Underlying Asset
Vega Option Price Volatility
Theta Option Price Time to Maturity
Rho Option Price Sensitivity to Risk-Free Rates
Let's put this into context with simple and concise examples of each.
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Delta - How much the Options Price will increase or decrease with a
$1 move in the Price of the underlying Instrument.
By Example:
Underlying Price of Instrument = $100
Options Premium = $2
Delta = $0.60
For instance - were the Price to move from $100 to $101 the Price of the
Option would increase by 60 Cents to $2.60.
Were the Price to decline from $100 to $99 in the underlying instrument,
the Price of the Option would decline to $1.40 ($2.00 - $0.60).
It is extremely important to understand Implied Delta is to occur at
any point in time prior to or upon Expiration.
Think of Delta as the Probability of your Options Potential, as well,
it is actually the Number of Shares relative to the Options 100 Share
implied leverage.
An out-of-the-money Call Option with a 0.25 Delta has an estimated 25%
probability of being in the money at expiration.
A deep-in-the-money call option with a 0.90 Delta has an estimated 90%
probability of being in the money at expiration.
A Delta of 1 cannot occur as it implies Par with the underlying instrument
and provides Zero incentive/profit Potential. This is important as we can
observe it would be far more intelligent to purchase the underlying outright.
For example, with a Delta of 1, for every $ move higher in the underlying,
the option price would rise by $100. As you can see there is no incentive to
simply not purchase the underlying instrument, it becomes a zero-sum
game.
Think of Delta in its simplest form with respect to Leverage.
Delta in my example above is $0.60 - you are leveraging 60 Shares as
opposed to 100 @ a theoretical Delta of 1.
Delta's implied theoretical ranges:
Calls - 0 to 1
Puts - 0 to (-1)
Actual Range @ the Money
0.50 Delta - therefore a Trader is leveraging 50 shares.
Why?
Because a Trader does not technically own the shares.
Consider it the Options Writers Profit Margin or Vig.
The further in the Money on an options chain, the higher the
Probability your Option will have less Risk. Of course, there is
a premium to Risk/Reward as we move lower and away from the
underlying Instrument or Share Price.
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Gamma - How much Delta change with a $1 move in the underlying
Price.
Delta and Gamma are both affected by Price movements up or down
by $1 increments.
Continuing our Example above:
Underlying Price of Instrument = $100
Options Premium = $2
Delta = $0.60
Gamma = 0.012
For instance - were the Price to move from $100 to $101 the Price of the
Option would increase by 60 Cents to $2.60.
The Delta will change as it will include Gamma after the $1 Price increase:
Delta 0.60 + 0.012 or - 0.612, the New Delta or $2.612.
As the Option price moves towards In the Money, once again - Gamma will
increase.
It is important to lock down the context, these are Price relationships - Delta
and Gamma.
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Theta - Options Prices decrease as Time passes moving to the Expiration Date
aka "Time Decay"
There are 2 distinct variables to decay.
1. Intrinsic Value: Simply put a Call option will have Intrinsic Value when the
underlying Asset is above the Strike price of the Option.
By Example:
Underlying Price of Instrument = $100
Option Strike Price = $90
Intrinsic Value of Call Option = $10 ($100 - $90)
Intrinsic Values can only range from Zero to a Positive number.
For Put Options, the Value is the opposite, or when the
underlying Aesst is below the Strike Price of the Option.
Underlying Price of Instrument = $100
Option Strike Price = $110
Intrinsic Value of Call Option = $10 ($110 - $100)
Intrinsic Value is Directly related to Price and only changes when
the underlying Price changes.
Time has no impact on an Options Intrinsic Value given there is
no change in the price of the Underlying Asset.
2. Extrinsic Value: aka "Time Value" or Options with more time
until expiration will have more Extrinsic Value than Options with
less time until Expiration for the same underlying Asset for the same
Expiration Cycle. ie. OPEX Date.
Why?
Over time Price ranges have the potential to expand and contract.
Expansion leads to Contraction and vice versa.
LEAP Options - 365 or more Days to Expiration have immense
Extrinsic Value due to the component of time.
It is important to note Theta begins its larger declines within 30 to 45
Days of Expiration. Theta goes steeply negative within this timeframe
with a very High Probability.
"Time" truly is Money - Extrinsically.
Less Time, less Extrinsic Value, less Money.
Options lose Time Value (Extrinsic) - Theta is expressed as a Negative
Number.
By Example:
Underlying Price of Instrument = $100
Theta = $0.50
Time to Expiration = 10 Days
Option Strike Price = $90 ($10 Intrinsic Value)
Theta (decay) $0.50 X Time (duration) 10 Days = $5.00 of Extrinsic loss
over Time to Expiration (Theta).
Projected Theta Burn (decay) implies the Price of the Option will be $95.
* This assumes there is No Change in Implied Volatility (More on this later).
It is important to note when your Portfolio may show a steady change in
Portfolio Theta, this is should not be assumed to be a linear function as
Delta or Change is the only Constant. Markets move Higher and Lower
with increasing Volatility.
Changes can and are significant.
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Vega - Changes in an Options Value with respect to a 1% Change in
Volatility or the Implied Volatility (aka the Widow Maker).
Why the Widow Maker?
If (IV) Implied Volatility drops significantly while the Underlying Asset's
Price remains constant. This is an extreme example, but one that has
become increasingly more common since September of 2021.
Implied Volatility is the expected change to Price in the Underlying Asset's
can change over time. Consider it the Price Range.
It is important to remember an Options Price must change for Implied
Volatility to change.
Simply Put - a change in demand for an Option over time will determine
its Implied Volatility.
Supply becomes a Factor as Risk (implied volatility changes) - you would
not want to assume the Risk of selling Naked Puts in a downtrend. Supply
would decrease and Premiums would rise. The overall level of confidence
and Fear would dictate demands while Supply would Price Risk.
Conversely - and this is the Key, any option with a Higher Extrinsic Value
will have higher Implied Volatility.
By Example:
Underlying Asset 1
Price = $110
Call = $100
IV = .69
Underlying Asset 2
Price = $105
Call = $100
IV = .47
A favorite time for the IV Crush is into Earnings of the Underlying as
Volatility drops significantly aka - Buy the Rumor, Sell the News.
As well, the timing of VIX Roll to Settle play a very large Role in
Vega, as does the term Structure of the VIX Curve.
Timing and Positioning in Time are the leys to the proverbial Kingdom
in Options Trading.
An Options Price changes by its Vega with a corresponding move in the
Underlying Price of the Assets, Implied Volatility will rise by 1%
By Example:
Underlying Price of Instrument = $100
Option Strike Price = $90
Intrinsic Value = $10
Vega = 0.25
Implied Volatility = 60%
Option Price $10 + Vega $0.25 = $10.25
Implied Volatily = 60% + 1% = 61%
What has the highest exposure to Vega?
Options At the Money and those with High Extrinsic Values.
Remember, Volatility scales with Time, contraction to expansion.
By Example:
Implied Volatility is expressed on a 365 Day Basis.
$100 Underlying Price
Implied Volatility = .25
We can simply calculate the Range for the Underlying Price
for the next 30 days:
1 Month Range = $100 x 0.25 x Square Root (30/365)
Or $3.45 either side of $100
Or $103.45 to $96.65
or a $6.90 range.
Finally - and of extreme importance: The shorter the Duration the more Extremes in Volatility
affect Price.
A large Decrease or Increase in an Underlying Assets price will have a far more pronounced
effect on Options of shorter Duration.
Melt ups and Melt Downs can be anticipated for Large moves in Leverage and isn't this what
today's Options Trader is seeking.. the answer is yes, absolutely.
The Setups require patience and an Edge over the Greeks.
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Rho - Measures the sensitivity of the option price relative to interest rates.
A benchmark Interest Rate increases by 1% - Option Prices will change
by Rho's Value as a percentage.
Rho is presently within an arrangement unseen in prior Cycles, be it Business
or Credit.
The Treasury Curve, as well as the Effective Funds Rate, have direct Impacts
upon Rho.
Underlying's Alpha (Which has lower Volatility and higher Pricing Power) has less
sensitivity to Rho - to a point, a point where Rates become too burdensome
on the Economy.
Underlying Beta (Which has Higher Volatility and Lower Pricing Power) has more
sensitivity to Rho as forward Earnings are more steeply discounted to Low Beta or
low to high Alpha.
Given the tumultuous environment currently, Rho is being turned on its head as this
Cycle is quite frankly unlike any in history. it Rhymes, yes, its repeat will be similar
to Long Cycle Durations.
This primarily due to the expansion of Credit and Default/Liquidity Risks present
which are unseen in Human History.
In prior expansions, rising yields had a profound effect on Bank's Balance Sheets.
That was then, Rho would provide a lift to Delta increasing the Value of an option.
The exact opposite is beginning to occur now and will likely stay in trend for some
time.
The math is exactly the same as above, this is where you, dear trader get to exercise
your skills in what you have learned.
Reminder:
Delta and Gamma are Price Calculated in $1 Increments.
Theta, Vega, and Rho are Percentage Calculated in 1% Increments.
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This week will be particularly challenging given the sheer size of this Expiration @
Quad Witching in Septenber 16th.
With CPI due Wednesday and the FOMC the following week.
It's going to be Volatile in the extreme.
I hope this helped you in gaining an Edge with respect to trading Options.
Trade Safely, with the Edge, and Good Luck this Week.
- HK
Please remember the VIX roll to Settle Strategies I discussed here -
