Doesn’t Stock Option Trading Require The Use Of “Greeks”?
Posted by Pete Stolcers on July 18, 2007
Option Trading Question
Why don't you talk much about the Greeks?
Option Trading Answer
What an astute observation and a great question! I don’t dwell on the “Greeks” like many option sites do.
There are two approaches to trading options. One focuses on the option prices and it looks for pricing disparities. It plans strategies around those disparities. Using that approach, the “Greeks” are very important. One example might be a volatility skew. A back-spread strategy might be used to take advantage of it. Another example is an implied volatility deviation where the options are relatively cheap relative to their historic value. In these cases, buying straddles or strangles might make sense. Neutral trading like condors and butterflies also requires extensive knowledge of the price behavior for each leg of the position and the aggregate position. The “Greeks” are also used to estimate profit loss scenarios over various price levels and time horizons. This is a valuable tool for complex multi-legged positions. After trading this way for many years I learned that this method was not nearly as effective as what I do now.
The second approach to option trading starts with extensive market and stock analysis. I’m a directional trader and I use options to leverage surrogate stock positions. I use my opinion of the underlying stock to guide me to the optimal strategy. It’s critical to nail down the direction, duration, and magnitude of the move. These variables along with my level of confidence (in the market, in my analysis and in my recent performance) determine the strategy.
This is how I trade and this is what I teach. I do reference delta when I talk about my expectations for a stock. In instances where I’m looking for a nice steady long-term trend, I suggest buying long-term in the money call options that have very little time premium. Translation: the delta is high and I want to gain point for point with the underlying stock. In other instances where an explosive move is projected, I suggest out of the money options. Translation: get long gamma. When I sell a front month put credit spread I talk about accelerated time premium decay. Translation: get short theta.
I discuss all of the option pricing principles without having to get into the Greeks. When I talk about implied volatility I reference how it compares to its historical implied volatility and that is used as a gauge to determine if the options are relatively cheap or expensive. I don’t need to use the term Vega and I don’t need to discuss how it is calculated. I don’t want someone to have to take an advanced math course to understand why a particular strategy makes sense. Option trading can be very intuitive and I find many “educators” want to complicate it so that they can feel important. If you are accurately predicting the market and you’re accurately forecasting the price movement of the underlying stock, you are in great shape. You just need to use a handful of basic strategies to capitalize on the move. Let your opinion drive your strategy and you will do well trading options (if you know how to pick a stock).
I have attended seminars where the instructor is teaching students the importance of identifying a kurtosis probability distribution - give me a break. Keep it simple. It is good to know what the “Greeks” represent and to understand option pricing principles. You don’t need to use the actual value for each to construct a position. The most optimal “Greek” position won’t make any money if you can’t get the stock right.
Thanks for the great question. This was something I should have addressed long ago.