Trading Option Greeks

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3 Praise for Trading Option Greeks How Time, Volatility, and Other Pricing Factors Drive Profit by Dan Passarelli A must-read for individuals who are serious about trading options James Bittman Author, Trading Options as a Professional Dan s book is a primer for options aficionados. Without bogging you down with superheavy math, he walks you through the key principles and shows you what matters the most to your trading portfolio. Fari Hamzei Founder, Hamzei Analytics, LLC

5 Trading Option Greeks

6 Related titles also available from Bloomberg Press BLOOMBERG MARKET ESSENTIALS: TECHNICAL ANALYSIS Fibonacci Analysis by Constance Brown DeMark Indicators by Jason Perl Option Strategies for Directionless Markets by Anthony J. Saliba with Joseph C. Corona and Karen E. Johnson Breakthroughs in Technical Analysis edited by David Keller Trading ETFs by Deron Wagner Technical Analysis Tools by Mark Tinghino New Insights on Covered Call Writing by Richard Lehman and Lawrence G. McMillan The Trader s Guide to Key Economic Indicators by Richard Yamarone New Thinking in Technical Analysis edited by Rick Bensignor A complete list of our titles is available at www/bloomberg.com/books Attention Corporations This book is available for bulk purchase at special discount. Special editions or chapter reprints can also be customized to specifications. For information, please Bloomberg Press, press@bloomberg.com, Attention: Director of Special Markets, or phone

7 Trading Option Greeks How Time, Volatility, and Other Pricing Factors Drive Profit Dan Passarelli Foreword by William J. Brodsky Chairman and CEO, Chicago Board Options Exchange Bloomberg Press New York

8 by 2008 Dan Passarelli. All rights reserved. Protected under the Berne Convention. Printed in the United States of America. No part of this book may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher except in the case of brief quotations embodied in critical articles and reviews. For information, please write: Permissions Department, Bloomberg Press, 731 Lexington Avenue, New York, NY or send an to press@bloomberg.com. BLOOMBERG, BLOOMBERG ANYWHERE, BLOOMBERG.COM, BLOOMBERG MARKET ESSENTIALS, Bloomberg Markets, BLOOMBERG NEWS, BLOOMBERG PRESS, BLOOMBERG PROFESSIONAL, BLOOMBERG RADIO, BLOOMBERG TELEVISION, and BLOOMBERG TRADEBOOK are trademarks and service marks of Bloomberg Finance L.P. ( BFLP ), a Delaware limited partnership, or its subsidiaries. The BLOOMBERG PROFESSIONAL service (the BPS ) is owned and distributed locally by BFLP and its subsidiaries in all jurisdictions other than Argentina, Bermuda, China, India, Japan, and Korea (the BLP Countries ). BFLP is a whollyowned subsidiary of Bloomberg L.P. ( BLP ). BLP provides BFLP with all global marketing and operational support and service for these products and distributes the BPS either directly or through a non-bflp subsidiary in the BLP Countries. All rights reserved. Long-Term AnticiPation Securities (LEAPS) is a registered trademark of the Chicago Board Options Exchange. Standard & Poor s 500 (S&P 500) and Standard & Poor s Depository Receipts sm (SPDRs) are registered trademarks of the McGraw-Hill Companies, Inc. PowerShares QQQ is a registered trademark of Invesco PowerShares Capital Management LLC. NASDAQ-100 Index is a registered trademark of The NASDAQ Stock Market, Inc. This publication contains the author s opinions and is designed to provide accurate and authoritative information. It is sold with the understanding that the author, publisher, and Bloomberg L.P. are not engaged in rendering legal, accounting, investment-planning, or other professional advice. The reader should seek the services of a qualified professional for such advice; the author, publisher, and Bloomberg L.P. cannot be held responsible for any loss incurred as a result of specific investments or planning decisions made by the reader. First edition published Library of Congress Cataloging-in-Publication Data Passarelli, Dan. Trading option greeks: how time, volatility, and other pricing factors drive profit/dan Passarelli; foreword by William J. Brodsky. p. cm. Includes index. Summary: Trading Option Greeks shows how to unlock the power of greeks trading by applying the unique characteristics of options, including volatility, time, delta, and more. Veteran floor trader and trainer to thousands, Dan Passarelli provides specific strategies and details on how to use spreads to take advantage of changes in the greeks Provided by publisher. ISBN (alk. paper) 1. Options (Finance) 2. Stock options. 3. Derivative securities. I. Title. HG6024.A3P dc

9 This book is dedicated to Kathleen, Sam, and Isabel. I wouldn t trade them for all the money in the world.

10 viii DISCLAIMER This book is intended to be educational in nature, both theoretically and practically. It is meant to generally explore the factors that influence option prices so that the reader may gain an understanding of how options work in the real world. This book does not prescribe a specific trading system or method. It is surely not a recipe for getting rich quick. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Examples may or may not be based on factual or historical data. In order to simplify the computations, examples may not include commissions, fees, margin, interest, taxes or other transaction costs. Commissions and other costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax adviser about potential tax consequences. Past performance is not a guarantee of future results. Options involve risks and are not suitable for everyone. Although much of this book focuses on the risks involved in option trading, there are market situations and scenarios that involve unique risks that are not discussed. Prior to buying or selling an option, a person should read Characteristics and Risks of Standardized Options (ODD). Copies of the ODD are available from your broker, by calling OPTIONS, or from The Options Clearing Corporation, One North Wacker Drive, Chicago, Illinois

11 Contents Acknowledgments Foreword by William J. Brodsky Introduction x xi xiii Part I The Basics of Option Greeks 1 1 The Basics 3 2 Greek Philosophy 23 3 Understanding Volatility 53 4 Option-Specifi c Risk and Opportunity 71 5 An Introduction to Volatility-Selling Strategies 92 6 Put-Call Parity and Synthetics Rho Dividends and Option Pricing 141 Part II Spreads Vertical Spreads Wing Spreads: Condors and Butterflies Calendar and Diagonal Spreads 201 Part III Volatility Delta-Neutral Trading: Trading Implied Volatility 13 Delta-Neutral Trading: Trading Realized Volatility Studying Volatility Charts 264 Part IV Advanced Option Trading Straddles and Strangles Complex Spreads The Trader s Thought Process 321 Index 326

12 Acknowledgments A book like Trading Option Greeks is truly a collaboration of the efforts of many people. In my years as a trader I had many teachers in the School of Hard Knocks. I have had the support of friends and family during the trials and tribulations throughout my trading career, as well as during the time spent writing this book. Surely there are hundreds of people whose influences contributed to the creation of this book, but there are a few in particular to whom I d like to give special thanks. I d like to give a very special thanks to my mentor and friend from the CBOE s Options Institute, Jim Bittman. Without his help this book would not have been written. Thanks to Marty Kearney and Joe Troccolo for looking over the manuscript. Their input was invaluable. Thanks to Debra Peters for her help during my career at the Options Institute. Thanks to Bob Kirkland and the late Steve Fossett for believing in me. Thanks to the staff at Bloomberg Press, especially Stephen Isaacs and Evan Burton. Thanks to my friends at the Chicago Board Options Exchange, the Options Industry Council, and the CME group. Thanks to my wife, Kathleen, who has been more patient and supportive than anyone could reasonably ask for. And thanks, especially, to my students and those of you reading this book. There are also a few websites that are full of valuable tools and information that deserve special mention: The Option Industry Council s website, 888options.com; The Chicago Board Option Exchange s site, cboe.com; ivolatility.com; and x

13 Foreword Today s option markets are the tightest, most liquid, and most actively traded markets in the history of listed-options trading. This thriving trading environment has led to greater competition among market makers and market takers alike. Such robust competition almost always creates opportunities for traders, and today s options markets are no exception. It is truly a great time to be an options trader. However, in order to succeed, today s options traders have to be smarter than ever before. Over the past several years, many esteemed options experts have written books on options basics. In fact, the beneficiaries of this knowledge have helped contribute to the recent surge in trading activity. However, in order to compete in today s rapidly evolving marketplace, new entrants must be armed with more knowledge than those who began trading even a few years earlier needed. Dan Passarelli s book Trading Option Greeks provides traders with the knowledge to successfully navigate today s option markets, which include a host of new products, strategies, and rules. When retail portfolio margining was introduced, in early 2007, the playing field was largely leveled for small retail traders and big professionals. Before portfolio margining, retail traders were inhibited by high margin requirements and often couldn t trade the same strategies as professionals do. Now the only barrier to a retail trader s trading some of the advanced strategies previously reserved for professional traders is knowledge. Options markets have also seen a seismic shift in the new-product area, most notably with the emergence of volatility as an asset class. Options traders have long relied on the VIX (the Chicago Board Options Exchange Volatility Index) to measure market volatility, but with CBOE s launch of options on VIX, in 2006, today s options traders can now trade volatility itself. VIX options quickly became xi

14 xii Foreword among the most successful new products in the history of the industry, and CBOE has since rolled out an entire suite of volatility products. Dan helps prepare traders for this new, more sophisticated options arena. Throughout this book, he discusses extensively the time component of options prices. Several chapters discuss in great depth trading volatility, put-call parity, rho (or interest rate risk), and dividends. Few books discuss the advanced concepts of options pricing as Trading Option Greeks does. Those that do tend to take a strictly mathematical or academic approach. Dan offers a practical approach that illustrates how the reader can apply the concepts to real-world trading scenarios. Throughout Trading Option Greeks, Dan conveys a perspective unlike that of most other authors: that of a market maker. Dan traded as a market maker on the floor of the CBOE for seven years. Following his floor-trading career, he began sharing his insights with retail and institutional traders as an instructor with the CBOE s Options Institute. Dan writes from a unique perspective from which traders of all experience levels can benefit, making Trading Option Greeks a must-read for option traders. William J. Brodsky Chairman and CEO Chicago Board Options Exchange

15 Introduction The first listed options contract was traded on the Chicago Board Options Exchange. Chicago is, incidentally, the home of the wellknown Union Stockyards, which thrived in the latter half of the 1800s and first half of the 1900s. The stockyards prided themselves on having very little waste from their slaughterhouses. They were said to use everything but the squeal. The options and futures markets, having evolved out of the agricultural and livestock industries, still hold that mentality. The concept of seizing all opportunities has always been part of the derivatives culture. This mentality allows traders to maximize their profits by taking into account everything they see in the market and wasting no opportunity. The need to seize opportunities that don t always fit into the traditional paradigm has led to the growth and success of the options market. In recent years, from 2000 to 2005, average daily trading volume for exchange-listed options increased a total of around 107 percent. Average daily volume for stocks listed on the New York Stock Exchange increased by a total of about 53 percent during that same period. In late 2007, growth in option volume was still continuing to outpace growth in stock volume. From the outside looking in, the esoteric game of the Wall Street or LaSalle Street trader seems to be a world away from a stay-athome trader with an online, self-directed trading account. In the past, these were two mutually exclusive groups, but now the lines are blurring. It is easy to assume that market makers and other professional traders have closely kept secrets to their ways of trading. In fact, nothing could be further from the truth. If there are any secrets of professional traders, this book will expose them. The real wall between the options pro and the average Joe was built from other inequities: commissions, bid-ask spreads, and margin requirements. This wall is crumbling. xiii

TRADING OPTION GREEKS

TRADING OPTION GREEKS Since 1996, Bloomberg Press has published books for financial professionals on investing, economics, and policy affecting investors. Titles are written by leading practitioners and