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Options Trading 101 - The Ultimate Beginners Guide To Options

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August 5, 2011 0 comments

Theta and Vega are two of the most important concepts to understand in options trading. In this post, I’ll discuss the importance of theta and vega for options trading in general and how they can be so important when learning to trade Credit Spreads and Iron Condors.

 

Theta is defined as: a measure of the time decay of an option, or the dollar amount that an option will lose each day. Theta measures and explains the effect that time has on the price of an option.

To be more specific, the theta value of an option tells us exactly how much extrinsic value an option will lose in a day, and by “day” we mean a 24-hour period, rather than a trading day.  Theta does not affect all options the same.  Since an option with a far-away expiration date has more time in which to move, the theta value for a long-dated option will be quite low; but as the contract moves closer to expiration, the theta value will increase.  

So, how does theta affect options pricing and more importantly our trading?   That depends entirely on whether you are long or short an option.  Long calls and puts will always have negative theta values, since the value of long contracts decreases as time ticks away.  Conversely, short options have positive theta, and become more profitable as they get closer to expiration. You may have noticed when trading long options, that the underlying stock moves in the direction that you want, but the option value may have decreased. This will be due to either theta decay, or a reduction in volatility. The opposite can be said when you are short options. The underlying stock may move in the wrong direction for your trade, but you might still be in profit. This would be due to either theta decay working in your favour, or a reduction in volatility. 

Another interesting aspect of theta is that it does not decay/accrue at a linear rate.  Instead, the theta value of an option may change very slowly while it is very far away from expiration, and then will change increasingly rapidly as expiration nears. For more information on this, please read this post on Credit Spreads and time value. 

Another excellent way to take advantage of theta decay is through calendar spreads or diagonal spreads as they are also known.  A long dated LEAP will lose theta very slowly, while short front-month options lose value quickly resulting in a net gain from time decay.

In order to help understand the impact of theta on a position, let’s look at a SPY Sept $120 Call.  It’s currently early August and SPY is trading at around $121. The Sept $120 call is currently trading at $4.90 and has a theta of -0.05.  If price and implied volatility remained the same until the next day, this long option price would fall $0.05 (or $5 in total value) purely due to the passage of time.

 

Vega is defined as the amount that the price of an option changes compared to a 1% change in volatility. An option’s vega is a measure of the impact of changes in the underlying volatility on the option price.

Volatility is a key aspect of options pricing, and a solid understanding is crucial when trading Credit Spreads and Iron Condors.  

All else being equal, option prices will increase if there is an increase in volatility and decrease if there is a decrease in volatility.  Therefore, it stands to reason that buyers of options (those that are long either calls or puts), will benefit from increased volatility and sellers will benefit from decreased volatility.  There are two measures of volatility, Historical Volatility and Implied Volatility:

Historical Volatility – is calculated by measuring the stocks past price movements.  This is a known figure as it is based on past data.  Stocks that have had large price swings in the past will have high levels of Historical Volatility.

As options traders, we are more interested in how volatile a stock is likely to be during the duration of our trade.  Historical Volatility will give some guide to how volatile a stock is, but that is no way to predict future volatility.  The best we can do is estimate it and this is where Implied Volatility comes in.

Implied Volatility – is an estimate, made by professional traders and market makers of the future volatility of a stock.  It is a key input in options pricing models.

The Black Scholes model is the most popular pricing model, and while I won’t go into the calculation in detail here, it is based on certain inputs, of which Vega is the most subjective (as future volatility cannot be known) and therefore, gives us the greatest chance to exploit our view of Vega compared to other traders.

Implied Volatility takes into account any events that are known to be occurring during the lifetime of the option that may have a significant impact on the price of the underlying stock.  This could include and earnings announcement or the release of drug trial results for a pharmaceutical company.  The current state of the general market is also incorporated in Implied Volatility.  If markets are calm, volatility estimates are low, but during times of market stress volatility estimates will be raised. One very simple way to keep an eye on the general market levels of volatility is to monitor the VIX Index. 

Stocks with a high beta, or stocks that experience large moves in comparison to the general market, will have higher levels of volatility inherent in their option prices.  As a result, the options of similarly priced stocks often have vastly different premiums.  

As an example, let’s look at a stock priced at 50.  Consider a 6-month call option with a strike price of 50:

If the implied volatility is 90, the option price is $12.50
If the implied volatility is 50, the option price is $7.25
If the implied volatility is 30, the option price is $4.50

These premiums are very different.  The point for you to remember is you can receive a higher cash premium when you sell options, if the underlying stock is volatile.

Credit Spreads and Iron Condors are two strategies that will benefit from high levels of volatility, if you have a view that the volatility will fall during the course of the trade.  Let’s assume that volatility has had a recent spike due to some market turbulence and you place a bull put spread.  All other things being equal, if volatility then falls back down to previous levels, you will have made a profit on the trade.  Any trade such as a Credit Spread or Iron Condor that are net selling trades, where you receive premium income, will benefit from a fall in volatility after you place the trade.  So, in order to have a greater chance of success with these trades, we should be looking for spikes in volatility as one criterion for our entry point.

 

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Options Trading 101 - The Ultimate Beginners Guide To Options

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