TRADINGOPTION GREEKS

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TRADINGOPTION GREEKS

How Time, Volatility, and Other PricingFactors Drive Profits

Second Edition

Dan Passarelli

Copyright ª 2012 by Dan Passarelli. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

First edition was published in 2008 by Bloomberg Press.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Passarelli, Dan, 1971-

Trading options Greeks : how time, volatility, and other pricing factors drive profits /

Dan Passarelli. � 2nd ed.

p. cm. – (Bloomberg financial series)

Includes index.

ISBN 978-1-118-13316-3 (cloth); ISBN 978-1-118-22512-7 (ebk);

ISBN 978-1-118-26322-8 (ebk); ISBN 978-1-118-23861-5 (ebk)

1. Options (Finance) 2. Stock options. 3. Derivative securities. I. Title.

HG6024.A3P36 2012

332.64053—dc23

2012019462

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

This book is dedicated to Kathleen, Sam, and Isabel. I wouldn’t tradethem for all the money in the world.

Disclaimer

This book is intended to be educational in nature, both theoretically andpractically. It is meant to generally explore the factors that influence optionprices so that the reader may gain an understanding of how options work inthe real world. This book does not prescribe a specific trading system ormethod. This book makes no guarantees.

Any strategies discussed, including examples using actual securities andprice data, are strictly for illustrative and educational purposes only and are notto be construed as an endorsement, recommendation, or solicitation to buy orsell securities. Examples may or may not be based on factual or historical data.

In order to simplify the computations, examples may not include com-missions, fees, margin, interest, taxes, or other transaction costs. Commissionsand other costs will impact the outcome of all stock and options transac-tions and must be considered prior to entering into any transactions. Investorsshould consult their tax adviser about potential tax consequences. Past per-formance is not a guarantee of future results.

Options involve risks and are not suitable for everyone. While much ofthis book focuses on the risks involved in option trading, there are marketsituations and scenarios that involve unique risks that are not discussed.Prior to buying or selling an option, a person should read Characteristics andRisks of Standardized Options (ODD). Copies of the ODD are available fromyour broker, by calling 1-888-OPTIONS, or from The Options ClearingCorporation, One North Wacker Drive, Chicago, Illinois 60606.

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Contents

Foreword xiii

Preface xv

Acknowledgments xix

PART I: THE BASICS OF OPTION GREEKS

CHAPTER 1The Basics 3Contractual Rights and Obligations 3ETFs, Indexes, and HOLDRs 9Strategies and At-Expiration Diagrams 10

CHAPTER 2Greek Philosophy 23Price vs. Value: How Traders Use Option-Pricing Models 24Delta 25Gamma 32Theta 38Vega 42Rho 46Where to Find Option Greeks 51Caveats with Regard to Online Greeks 52Thinking Greek 53Notes 53

CHAPTER 3Understanding Volatility 55Historical Volatility 55Implied Volatility 58Expected Volatility 61Implied Volatility and Direction 67

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Calculating Volatility Data 68Volatility Skew 69Note 72

CHAPTER 4Option-Specific Risk and Opportunity 73Long ATM Call 73Long OTM Call 79Long ITM Call 83Long ATM Put 84Finding the Right Risk 89It’s All About Volatility 89Options and the Fair Game 93Note 94

CHAPTER 5An Introduction to Volatility-Selling Strategies 95Profit Potential 95

CHAPTER 6Put-Call Parity and Synthetics 113Put-Call Parity Essentials 113American-Exercise Options 119Synthetic Stock 120Synthetic Stock Strategies 124Theoretical Value and the Interest Rate 132A Call Is a Put 133Note 133

CHAPTER 7Rho 135Rho and Interest Rates 135Rho and Time 137Considering Rho When Planning Trades 138Trading Rho 142Notes 143

CHAPTER 8Dividends and Option Pricing 145Dividend Basics 145Dividends and Option Pricing 147Dividends and Early Exercise 148Inputting Dividend Data into the Pricing Model 152

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x Contents

PART II: SPREADS

CHAPTER 9Vertical Spreads 163Vertical Spreads 164Verticals and Volatility 178The Interrelations of Credit Spreads and Debit Spreads 180Building a Box 181Verticals and Beyond 183Note 183

CHAPTER 10Wing Spreads 185Condors and Butterflies 185Taking Flight 185Keys to Success 194Greeks and Wing Spreads 195Directional Butterflies 195Constructing Trades to Maximize Profit 198The Retail Trader versus the Pro 205Notes 207

CHAPTER 11Calendar and Diagonal Spreads 209Calendar Spreads 209Trading Volatility Term Structure 218Diagonals 228The Strength of the Calendar 233Note 233

PART III: VOLATILITY

CHAPTER 12Delta-Neutral Trading: Trading Implied Volatility 237Direction Neutral versus Direction Indifferent 237Delta Neutral 238Trading Implied Volatility 241Conclusions 247

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Contents xi

CHAPTER 13Delta-Neutral Trading: Trading Realized Volatility 253Gamma Scalping 254Art and Science 258Gamma, Theta, and Volatility 259Gamma Hedging 259Smileys and Frowns 265

CHAPTER 14Studying Volatility Charts 269Nine Volatility Chart Patterns 269Note 282

PART IV: ADVANCED OPTION TRADING

CHAPTER 15Straddles and Strangles 285Long Straddle 285Short Straddle 293Synthetic Straddles 298Long Strangle 299Short Strangle 302Note 306

CHAPTER 16Ratio Spreads and Complex Spreads 307Ratio Spreads 307How Market Makers Manage Delta-Neutral Positions 316Trading Skew 321When Delta Neutral Isn’t Direction Indifferent 322Managing Multiple-Class Risk 323

CHAPTER 17Putting the Greeks into Action 325Trading Option Greeks 326Choosing between Strategies 326Managing Trades 329The HAPI: The Hope and Pray Index 329Adjusting 330

About the Author 333

Index 335

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xii Contents

Foreword

The past several years have brought about a resurgence in market volatilityand options volume unlike anything that has been seen since the closeof the twentieth century. As markets have become more interdependent,interrelated, and international, the U.S. listed option markets have solidifiedtheir place as the most liquid and transparent venue for risk managementand hedging activities of the world’s largest economy. Technology, compe-tition, innovation, and reliability have become the hallmarks of the indus-try, and our customer base has benefited tremendously from this ongoingevolution.

However, these advances can be properly tapped only when the users ofthe product continue to expand their knowledge of the options product andits unique features. Education has always been the driver of growth in ourbusiness, and it will be the steward of the next generation of options traders.Dan Passarelli’s new and updated book Trading Option Greeks is a necessityfor customers and traders alike to ensure that they possess the knowledge tosucceed and attain their objectives in the high-speed, highly technical arenathat the options market has become.

The retail trader of the past has given way to a new retail trader of thepresent—one with an increased level of technology, support, capital treat-ment, and product selection. The impact of the staggering growth in suchproducts as the CBOE Holdings’ VIX options and futures, and the literallydozens of other products tied to it, have made the volatility asset class a new,unique, and permanent pillar of today’s option markets.

Dan’s updated book continues his mission of supporting, preparing, andreinforcing the trader’s understanding of pricing, volatility, market termi-nology, and strategy, in a way that few other books have been able. Using a

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