Many option traders will refer to the trifecta of option greeks as delta, theta and vega. But the next most important greek is gamma. Options gamma is a one of the so-called second-order options greeks. It is, if you will, a derivative of a derivative. Specifically, it is the rate of change of an option’s delta relative to a change in the underlying security.
Using options gamma can quickly become very mathematical and tedious for novice option traders. But, for newbies to option trading, here’s what you need to learn to trade using gamma:
When you buy options you get positive gamma. That means your deltas always change in your favor. You get longer deltas as the market rises; and you get short deltas as the market falls. For a simple trade like an AAPL January 565 long call that has a delta of 0.51 and gamma of 0.0115 , a trader makes money at an increasing rate as the stock rises and loses money at a decreasing rate as the stock falls. Positive gamma is a good thing.
When you sell options you get negative gamma. That means your deltas always change to your detriment. You get shorter deltas as the market rises; and you get longer deltas as the market falls. Here again, for a simple trade like a short call, that means you lose money at an increasing rate as the stock rises and make money at a decreasing rate as the stock falls. Negative gamma is a bad thing.
Start by understanding options gamma from this simple perspective. Then, later, worry about working in the math.
Today we are going to discuss an option strategy that you may not have thought about in quite some time. A straddle is an option strategy that traders can use when the market is volatile but direction is uncertain. Another play similar to the straddle is the option strangle. In a straddle, the trader is betting on both sides of a trade by purchasing options with the same strike price and the same expiration date, on the same underlying. A trader can create a similar trade, but with a lower price by trading a strangle instead. Rather than purchasing a put and a call at the same strike (which makes up a straddle), the trader purchases a put and a call at different strikes, still with the same expiration. By using a put and a call that are out-of-the-money (OTM), a trader pays a lower initial price. However, this comes with a price so-to-speak; the stock will have to make a much larger move than if the straddle were implemented. The trader is, arguably, taking a larger risk (because a bigger move is needed than with a straddle), but is paying a lower price. Like many trade strategies there are pros and cons to each. If this all sounds a little overwhelming to you, I would invite you to checkout the Options Education section on our website.
Like a straddle, a strangle has two breakeven points. To calculate these points simply add the net premium (call premium + put premium) to the strike price of the call (for upside breakeven) and subtract the net premium from the put’s strike (to calculate downside breakeven). If at expiration, the stock has advanced or dropped past one of these breakeven points, the profit potential of the strategy is unlimited (yes, unlimited). The position will take a 100% loss if the stock is trading between the put and call strikes upon expiration. Remember that the maximum loss a trader can take on a strangle is the net premium paid.
To create a strangle, a trader will purchase one out-of-the-money (OTM) call and one OTM put. We can use Apple (AAPL) as an example which at the time of this writing is trading at around $540 after a volatile couple if weeks. The trader would buy both a January 545 call and a January 535 put. For simplicity, we will assign a price of $17 for both – resulting in an initial investment of $34 for our trader (which again is the maximum potential loss).
Should the stock rally past $545 at expiration, the 535 put expires worthless and the $545 call expires in-the-money (ITM) resulting in the strangle trader collecting on the position. If, for example, the intrinsic value of the call at expiration is $38, the profit is $4 (intrinsic value less the premium paid). The same holds true if the stock falls below $535 at expiration, it then is the put that is ITM and the call expires worthless. The danger is that the stock moves nowhere by the time option expiration occurs. In this case, both legs of the position expire worthless and the initial $34, or $3,400 of actual cash, is lost.
Notice that the maximum loss is the initial premium paid, setting a nice limit to potential losses. Potential profits on the strangle are unlimited which can be very rewarding but as always, a traders needs to decide how he or she will manage the position.
One of the greatest advantages of options trading is its extreme flexibility in both the initial construction of positions and in the ability to adjust a position to match the new outlook of the underlying. The trader who limits his or her world to that of simply trading equities and ETF’s can only deal in terms of short or long. A change in an outlook often requires starting a new position or exiting the old one. The options trader can usually accommodate the newly developed outlook with much more fluidly, often with minor adjustments on the position in order to achieve the right fit with the new outlook.
One concept with which the trader needs to be familiar in order to construct the necessary adjustments is that of the synthetic relationships. Most options traders neglect to familiarize themselves with the concept when learning to trade options. This concept arises from the fact that appropriately structured option positions are virtually indistinguishable in function from the corresponding long or short equity/ETF position. One approach to remembering the relationships is to memorize all of the relationships. It may be easier to do this by remembering the mathematical formula and modifying as needed.
For those who remember high school algebra, the fundamental equation expressing this relationship is S=C-P. The variables are defined as S=stock, C=call, and P=put. This equation states that stock is equivalent to a long call and a short put.
Using high school algebra to formulate this equation, the various equivalency relationships can easily be determined. Remember that we can maintain the validity of the equation by performing the same action to each of the two sides. This fundamental algebraic adjustment allows us, for example, to derive the structure of a short stock position by multiplying each side by -1 and maintain the equality relationship. In this case (S)*-1 =(C-P)*-1 or –S=P-C; short stock equals long put and short call.
Such synthetic positions are frequently used to establish positions or to modify existing positions either in whole or part. You might have not liked algebra when you were in school, but applying some of the formulas can help an options trader exponentially!
Looking for an options trading system to give to someone in need or for yourself this Holiday Season? Let the Market Taker Mentoring Trading Path be your options trading guide.
The MTM Trading Path
The MTM Trading Path is a simple, but powerful proprietary options trading system designed to be a veritable options trading guide that outlines a step-by-step a plan for options trading. There are a total of eleven steps in this options trading system which begins with observing the market and discovering opportunities.
Options trading is, of course, more involved than stock trading. Specifically, there are two steps in this options trading guide that are not in a conventional trading plan. These steps center around analyzing volatility and selecting among the various strategies.
Options involve risk and are not suitable for all investors. Before trading options, please read Characteristics and Risks of Standardized Option (ODD) which can be obtained from your broker; by calling (888) OPTIONS; or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, IL 60606. The content on this site is intended to be educational and/or informative in nature. No statement on this site is intended to be a recommendation or solicitation to buy or sell any security or to provide trading or investment advice. Traders and investors considering options should consult a professional tax advisor as to how taxes may affect the outcome of contemplated options transactions.