Dear Reader,
There was nothing fun about watching the S&P 500 slide 25% this year, unless you were one of the few who were making money on the decline.
If you felt the horror of the decline, I certainly feel for you, but if you were wondering how to prosper from a declining market, well, understanding how to trade options could be your ticket.
I want you to become more confident with option trading, which can open many doorways to opportunities.
Here are a just a couple of recent opportunities that options traders could have capitalized on both the downward decline, and the short-lived bullish bounces that have occurred along the path.
By purchasing an October $384 put contract on September 20, your profit eight days later could have been 68% as the S&P fell over 4%.
Again, on October 12, had you purchased the 14 November $355 call option, 13 days later your return could have been 121% as the S&P 500 bounced higher by over 6%.
I’m not saying you’ve missed out and the opportunities are behind you – after all, these returns accounted for only 21 days of the year, and since there are 365 days in a year, there will be plenty of opportunities moving forward.
So, let’s talk about some of the driving forces that impact option values – the Greeks: those things about options that can inform you just how much money you’re capable of making.
Calls, Puts and Greeks – those behind-the-scenes things that every option trader should be aware of
From a very simple standpoint, if you’re bullish on a stock, you’ll buy a call option, and when you’re bearish, you can utilize long put options to make your money.
But there’s more to profiting from options besides simple up and down movements in the market.
Let’s talk a little about what option Greeks are and how they’ll impact your profitability as you trade options.
There are five option Greeks you’ll hear about – Delta, Gamma, Theta, Vega and Rho, but let me keep it simple for you and just focus on three of them: Delta, Theta and Vega, which are the driving forces behind option profitability.
The price of the stock, the amount of time available on an option contract and implied volatility are most critical considerations when it comes to trading options.
As you get a better understanding of the Greeks I mentioned, your confidence in trading options will grow because you’ll have a greater understanding on how the Greeks can impact your profitability.
I’ll use the image in illustration 1, below, and break it down for you.
(Illustration 1: Greeks for a Long Call and Long Put Option)
Delta:
Let’s start with the option Greek, Delta. To keep it simple, remember just two things:
- The Delta’s sign (+ or -) can indicate which direction the stock should move in order to benefit your trade, and…
- The value of the Delta refers to how much your investment might make or lose if the security moves up or down by one dollar.
So, look at the Delta value for the call option above. The sign is positive, which means the trade benefits when the stock rises in value.
And, if the stock’s price rises by $1.00, the investment is expected to gain $53.07 in value as well.
This is super helpful to you in determining how much money you can make as the stock’s price moves in your favored direction.
In the example of the call above, if you expected the stock’s price to rise higher by $5 in value, you would simply multiply the call Delta by 5. You’d expect that the five-dollar price increase could yield you $265 on your trade (53.07×5).
The opposite is also true, of course, so if the stock’s price falls by $1.00, we’d expect to lose $53.07 worth of value on the trade.
Another thing to remember is that the Greeks you will see on your option trade will fluctuate as the stock’s price changes – the Greeks can get bigger or smaller as price moves up or down.
Next, let’s talk about the impact that time takes on long calls and puts.
Theta:
I’ve mentioned it in many of my classes, but time is always working against us when we buy options.
As you can see from illustration 2, below, the same $146 strike price has a different market value depending on the number of days to expiration. The shorter the time remaining until the option expires, the less value that time has.
This means that as an option trader, we want the stock to move sooner than later. The quicker the stock’s price moves for us, the faster we can lock in the profits and avoid the erosion of time.
(Illustration 2: Extrinsic, or Time Value)
It’s also where the option Greek, Theta, comes in the picture. Theta tells us how much we can expect our extrinsic value (time value) to deteriorate on a daily basis.
If you look up at illustration 1, based on the theta value, the put contract is losing $17.85 of its market value every day – which is the biggest reason option buyers want the stock’s price to move favorably, and fast.
Traders that sell options for income will use Theta to give them a sense of how much of an option’s premium can be earned by each passing day.
The last option Greek is one that my VEGA BURSTS Traders really watch out for, because rising implied volatility is a key element to our profits when we trade around earnings time.
Vega:
Like Delta, the options Vega will have a positive or negative sign associated with it, which simply tells us if the trade will benefit from rising or declining implied volatility.
In illustration 1, both the call and put options in this scenario will benefit as implied volatility rises.
You can look at the Vega value to determine how much money you’ll be making or losing based on implied volatility rising or declining given a one percentage point rise or fall in implied volatility.
So, in the case of the call or put, if implied volatility rises by just one percentage point, the option’s value can increase by $43.53.
What causes implied volatility to rise or fall is a fair question to ask, and the easy answer is fear. The market illustrates investor fear when it’s falling – and as the market falls, implied volatility rises. As implied volatility rises, the market value of option premiums increases – and this can mean even more money in your pocket.
There’s a caveat to this, however. When stock prices are falling, implied volatility is rising and trading puts can be especially rewarding. The opposite is true as well. When a stock is climbing higher, implied volatility is usually falling under normal circumstances, and this can tear into the call buyer’s profits.
Your comfort level will increase as you trade options and expand your understanding of the inner workings of options. By having a little bit of knowledge regarding option Greeks, you will be better prepared to understand the universe of price, time and volatility might impact your profitability.
You’ll also be wiser in your decision making and find that you can improve your odds for success and profitability by understanding the Greeks.
Until next time,
Tom Gentile
America’s #1 Pattern Trader
Join Tom each Monday through Wednesday at 12:00 p.m. ET as he discusses a range of strategies to make money in a strained market environment.
Did you miss the Live session? Watch Tom’s replays!
