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TRADING FLOOR SECRETS: Choosing the Appropriate Strategy


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Scott Kramer, Optionetics.com
August 28, 2006


One of the most difficult and challenging activities a new, or even intermediate, trader is faced with is deciding which strategy is most appropriate for their goals, objectives, personality and account size. The wonderfully powerful benefit of being an option trader is number of the choices he or she has in deciding what to trade. Nothing is plain vanilla with options.  I will begin with a brief introduction of which variables a trader can participate in, and then I will go into helping you choose the best strategy/strategies for you.

Delta

With stock or futures trading, you are limited to placing a directional bet, either up or down in market direction. Option traders call this trading deltas. The problem with directional trading is that it is the most difficult method of trading to most people, myself included. Many months I feel like I would have been better off flipping a coin than looking at a chart. Option traders have delta, but we also have four other variables we can isolate and take advantage of. Some delta trades are long single options (either call or put) and vertical spreads.

Gamma

Gamma is the amount of change that the option''s deltas will experience for every 1-point move in the underlying. Gamma is best traded by being net long (long gamma) or short (short gamma) options primarily the “meaty” ATM options. Being long gamma is a strategic investment where the option owner believes that the underlying stock will move around dramatically. Being short gamma is the belief that the underlying has moved as rapidly as it will and most likely will slow down. When trading gamma, it doesn''t matter which direction the markets move, but rather the magnitude of the move. An example of a gamma trade would be long a straddle or strangle.

Though you are isolating gamma as the variable you want to focus on with a strategy such as a straddle, other variables can come into play that could affect your potential profitability (such as time decay and volatility). A thorough understanding of how these secondary variables participate is crucial to your long-term success so that you know how to avoid the pitfalls. For example, being long a straddle has the negative consequence of time decay working against you; however, if you are familiar with a powerful technique called gamma scalping, you can potentially sidestep the negatives. Whatever it costs to learn this correctly is worth it as the result of ignorance will possibly be many multiples of what the education was.

Theta

Theta is the measure of how much an option or options position loses on a daily basis and increases as time approaches expiration. Here the trader can say to him/herself, “I don''t know much but I do know that nobody has figured out how to stop time and I am going to attempt to make money on this.” An example of a position that makes money because of time decay is a time spread or short option position such as a short straddle.

This is not as easy of a trade as it sounds, but still usually more reliable than a delta bet. Like all positions, a theta position has a landmine you have to sidestep. Most theta positions require the market to stand still in order to profit. I can''t tell you the amount of times I was short straddles hoping the market wouldn''t move and it seems like volatility immediately increased, making the likelihood of a stable market seem unobtainable. Then I would hear the Rolling Stones song, “Time, time, time, is on my side…” and I would relax a little – very little.

Vega

Vega is the measure of how much an option changes value due to an increase or decrease in volatility. The great thing about vega trading is that there tends to be a pretty predictable range by which one can gain a foothold. Figure 1 below illustrates a 2-year history of the VIX, which measure the volatility in the Standard and Poor''s 500 index. You will please notice that there is almost always a relatively rapid move back to the statistical mean after a new high or low has been made. 



Figure 1: 2-Year, VIX

An example of a vega trade would be to purchase straddles or strangles when the volatility is low and sell the same when volatility is high. There are other vega trades that people may not be aware of by trading a position incorrectly. For example, when trading a time spread the trader who sells the front month option and purchases the next month out option is placing a theta trade. However, if you take the same trade and instead of buying the second month out trades a long LEAPS option, you are doing a vega trade. Another common misconception is when a trader does a collar with a long ITM LEAPS instead of stock. This is doing a vega trade in addition to a delta trade.

Rho

Rho is the measure of how much an option''s value will change when interest rates change. Unless you are trading long term options, rho tends to be relatively insignificant in today''s interest rate environment. An example of a rho trade would be owning a position known as a box spread in the far out months or LEAPS options. 

STRATEGIES

Now that you have a remedial understanding of how the greeks come into play with various strategies, it is time to determine which strategy to implement. Some people will trade all the strategies they can; others will trade as few as possible preferring to specialize. I will also let you in on the types of trades I do more often than not (though I have been known to do intricate things).

When starting out the K*I*S*S (Keep It Simple, Superman) principle is usually best for most people. Find one or two strategies that you like or meet your investment objectives and stick with it/them. The key is to not forget who you are inside. Many people, market makers included, want to play the home-run strategies but are not cut out for the stress associated with them. If you can''t watch the markets every day, then don''t pick a strategy that you may have to be on top of things all day long.

Some personal thoughts:

  • First, if you own stock you may want to learn how to collar the positions right away. I wrote an article last week showing an example in which even though the market sold off you would have still profited by having a collar on the stock (see The Lazy Stock Collar, 8/14/06). This is the real deal, people. I know many people who would have lost considerable money had it not been for the collar, instead are up way more than could have been reasonably expected by the traditional “buy and hold” method.
  • Collars can also be placed on portfolios of stocks (instead of each stock individually) by utilizing index options. 
  • Time spreads are excellent low maintenance strategies for people to learn many of the greeks simultaneously. Though not for everyone, I have found over the years of teaching that many people easily embrace this strategy once they understand how it the strategy works and how to profit by them. It is hard to get rich from a time spread, but it is also hard to crash and burn up a trading account.
  • Butterflies are good trades when starting out. The downside to these is that they are priced according to the probability of making money on the trade. If you do not understand what they are worth theoretically you can pay a little too much for them on every trade. This doesn''t sound too bad until you equate it to being in Vegas which makes their living by you paying a little too much for the potential reward. Unfortunately, even though what happens in Vegas stays in Vegas, but your spouse will find out about trading losses, so let''s try to avoid them. 
  • A great alternative, and one I have traded for almost 2 decades, is the broken-wing butterfly in which a trader pulls the furthest OTM tail away from the body. This is favorable in that it usually allows the trader to spread the strikes further apart and often enter for no debit. Try buying a traditional butterfly for no cost. Those who do not fully understand or appreciate the trade will deter you by pointing out the risk in them, which if done correctly can be minimized. These are usually the same people who sell a vertical spread feeling there is little risk, but do not like the BWB, which has even less risk. I know many market makers who have made their living on just this trade, but they are a little tricky to grasp and I do not recommend them unless you have spoken with someone who has been doing them for some time, as you are really supercharging you account and that needs to be done correctly. 
  • Gamma Scalping and Reverse Gamma Scalping is a good trade to do when volatility has broken outside the bands on the normal range where you know the odds can be in your favor. This requires patience as waiting for this condition often can take months for the right one to set up. If you are like me, however, you will eventually learn patience one way or the other. You will either take someone''s advice or pay the markets to teach you patience.
  • Vertical spreads are a good strategy for those who are better at picking market direction than I, as you can ride out moves against the desired path with more comfort than if you had the equivalent position in stock. I used them with more frequency on the trading floors than I do now as they were great foundations to piece together other trades. I still use them as a means of legging into more complicated trades like the butterfly, but less for a directional bias.

I hope this article helped, if not in assisting you in choosing the strategy that custom suits your needs, then to narrow down or eliminate which trades you want to fiddle with when honing your talents. Start out small, try everything a couple of times. Don''t quit until you have made and lost money with a strategy. Many people get burned the first time and then quit right before the miracle. If I had done that I would still be without a strategy to trade.

Lastly, keep learning. There use to be a television commercial for what I recall was Midas, where the mechanic said, “You can pay me now or you can pay me later.” This saying applies to trading with force. You can spend a little on education or a lot on mistakes hoping you learn the lesson by accident before you run out of money.  I wish it were easier than that, but then again if it were everyone would be doing it. Don''t quit before the miracle.  


Scott Kramer
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site
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