The Greeks Options are Not Stocks
Different Trading Skills Required
Whether you are a trader or an investor, your objective is to make money. And your secondary objective is to do so with the minimum acceptable level of risk.
One of the major difficulties for new options traders arises because they do not really understand how to use options to accomplish their financial goals. Sure, they all know that buying something now and selling it later at a higher price is the path to profits.
But that is not good enough for options traders because option prices do not always behave as expected.
For example, experienced stock traders do not always buy stock. Sometimes they know sell short -- hoping to profit when the stock price declines. Too many novice option traders do not consider the concept of selling options (hedged to limit risk), rather than buying them.
Options are very special investment tools and there is far more a trader can do than simply buy and sell individual options. Options have characteristics that are not available elsewhere in the investment universe. For example, there is a set of mathematical tools ("the Greeks") that traders use to measure risk. If you don't grasp just how important that is, think about this:
If you can measure risk (i.e,, maximum gain or loss) for a given position, then you can . Translation: Traders can avoid nasty surprises by knowing how much money can be lost when the worst-case scenario occurs.
Similarly, traders must know the potential reward for any position in order to determine whether seeking that potential reward is worth the risk required.
For example, a few factors that options traders use to gauge risk/reward potential:
- Holding a position for a specific period of time. Unlike stock, all options lose value as time passes. The Greek letter "Theta" is used to describe how the passage of one day affects the value of an option.
- Delta measures how a price change -- either higher or lower -- for underlying stock or index affects the price of an option.
- Continued price change. As a stock continues to move in one direction, the rate at which profits or losses accumulate changes. That is another way of saying that the option Delta is not constant, but changes. The Greek, Gamma describes the rate at which Delta changes.
This is very different for stock (no matter the stock price, the value of one share of stock always changes by $1 when the stock price changes by $1) and the concept is something with which a new options trader must be comfortable.
- A changing volatility environment. When trading stock, a more volatile market translates into larger daily price changes for stocks. In the options world, changing volatility plays a large role in the pricing of the options. Vega measure how much the price of an option changes when estimated volatility changes.
Hedging with Spreads
Options are often used in combination with other options (i.e. buy one and sell another). That may sound confusing, but the general idea is simple: When you have an expectation for the underlying asset, such as:
- Neutral (expecting a range-bound market)
- Becoming much more, or much less, volatile
You can construct positions that earn money when your expectations come true.
The number of possible combinations is large, and you can find information on a variety of option strategies that use spreads. Spreads have limited risk and limited rewards. However, in exchange for accepting limited profits, spread trading comes with its own rewards, such as an enhanced probability of earning money. The somewhat conservative investor has a big advantage when able to own positions that come with a decent potential profit -- and a high probability of earning that profit. Stock traders have nothing similar to option spreads.
Options trading is not stock trading. For the educated option trader, that is a good thing because option strategies can be designed to profit from a wide variety of stock market outcomes. And that can be accomplished with limited risk.