Trading Options for Edge

Mark Sebastian & Celeste Taylor

📚 GENRE: Business & Finance

📃 PAGES: 214

✅ COMPLETED: November 3, 2022

🧐 RATING: ⭐⭐⭐

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Short Summary

In Trading Options for Edge, Mark Sebastian and Celeste Taylor dive into the world of options and explain how to find an advantage when trading them. Among several topics, Sebastian and Taylor take a look at the impact market volatility has on options, how to trade various spreads, and why risk management is so important.

Key Takeaways

1️⃣ Identify an ‘Edge’ — When trading options or general stocks, look for an edge. An edge can mean a variety of things, from current information about a stock, volatility trends, or price movements. All in all, finding an edge involves doing your homework before executing the trade. Find some kind of information that is going to increase the trade’s probability of success. 

2️⃣ Options and Volatility — Volatility is the most important factor in options trading. There are two types of volatility you can look at when trading options: Implied Volatility (IV) and Realized Volatility (RV). Both can give you good insight when assessing an options trade. When volatility is high, the premium you can collect on options is generally high. When volatility is low, premium is low. 

3️⃣ The VIX — One of the best measures of volatility in the market is the VIX. Often referred to as “the fear index,” the Chicago Board Options Exchange (CBOE) Volatility Index (VIX) tracks expected 30-day volatility in the market by gauging premium received on S&P 500 Index (SPX) options. When the VIX is high, volatility is high and the S&P 500 is usually down. When the VIX is low, volatility is low and the S&P 500 is usually up. The VIX can give you a quick and easy look at volatility in the market. 

Favorite Quote

“Skills in evaluating realized volatility, implied volatility, and the overall market will enhance your trading skills.”

Book Notes 📑

Ch. 1: Trading in Options

  • Look for an Edge — When trading options, you always want to look for an ‘edge,’ whether it’s current news you know about, trends in option premium levels, or price movement involving the underlying stock. Before you pull the trigger on an options trade, make sure you have some kind of edge or advantage.  
  • Volatility — Generally, volatility is a good thing when it comes to options. The premium you can collect from selling options is greater when there’s a lot of volatility going on. 
  • Standard Operating Procedure (SOP) — Every great organization or team has operating procedures. The same should go for trading options. You need to outline a plan and stick to it. Having a plan takes some of the emotion out of investing and prevents you from getting too far off course. 

Ch. 2: Risk Management

  • Risk Management — Managing risks is one of the most important keys to trading. There are several components and things to understand about risk management, including:
    • The Option Pricing Model
    • The Options Greeks 
  • The Options Pricing Model — The model has five core inputs. These factors should be considered when looking at option contracts.
    • Price of the Underlying Stock
    • Strike Price
    • Time to Expiration 
    • Volatility 
    • Cost of Carry
  • The Options Greeks — Looking into these will help you manage your risk. The Greeks, and their associated risks, will change in response to volatility in the market. The key is to understand how the Greeks and the associated risks change as volatility changes. A few of the important Greeks include:
    • Delta — Represents the position’s sensitivity to changes in the underlying stock’s price. A call or put option’s delta rating hovers between 0-1 and can be thought of as the probability that the stock will land “in the money.”
    • Gamma — Indicates how the position’s delta changes as the underlying stock moves in one direction or the other. 
    • Vega — Measure of how the position makes or loses money as implied volatility (IV) changes. 
    • Theta — Represents how a position makes or loses money as time passes. With the passing of each day, how much is a trader making or losing by carrying the current position? 
  • Delta — Delta will move up and down for a variety of reasons.
    • Change in Underlying Price — When the price of the underlying stock goes up, delta goes up. When the price of the underlying stock goes down, delta goes down. Delta is best thought of as the percentage chance that the option will end up “in the money.”
    • Time to Expiration — The time to expiration will have a direct impact on delta. For example, a $200 call option on Apple (APPL) expiring next week when Apple is trading at $150 will have a low delta because there is a small chance that Apple will rally $50 per share in a week. But a $200 call option on Apple (APPL) expiring in a year when Apple is trading at $150 will have a higher delta because there’s more time for Apple to make that $50 per share move. 
    • Volatility — Volatility is an X-Factor when it comes to options, delta, and premium. High volatility in the market increases the chances of big swings in an underlying stock’s price, which means each option has a greater chance of ending up “in the money,” which will result in higher delta, which ends up resulting in greater premiums on option contracts.
      • Quote (P. 20): “The view of volatility is much like turning the clock back. A two-year scenario makes outcomes seem more likely to happen, and higher volatility makes scenarios more likely to happen.”
        • Takeaway — Higher volatility in the market, which can be gauged by looking at the VIX, will result in higher delta and options premiums because crazy swings in the underlying stock’s price (up or down) are more likely when there’s a lot of volatility than when there’s low volatility. 
  • Vega — An option’s vega tracks how the option’s price moves with changes in volatility. It moves up and down based on the following factors:
    • Change in Underlying Price — The higher the price of the underlying stock, the more vega it will have.
    • Strike Price — The closer the strike price is to the money, the more vega it will have. At-the-money options always have a high vega relative to the strikes that are out of the money. The further the strike price moves from the underlying stock’s price, the lower the vega.
    • Time to Expiration — Options with a longer time to expire are worth more and therefore have more vega.
    • Volatility — When there’s a lot of volatility in the market, it makes all options act like they are at-the-money, and options at-the-money have the most vega. Essentially, the more volatility in the market, the more vega an option will have because the high volatility makes it more likely that a stock’s price can make a big move and get closer to the at-the-money strike price. 
  • Theta — Theta is the rate at which an option loses value as time passes. Options lose value as time goes by. The process of an option’s value decreasing over time is what theta measures. Theta is impacted by the following factors:
    • Change in Underlying Price — Similar to vega, when the underlying stock price is high, the option will have a high theta.
    • Strike Price — At-the-money options have the highest premium. These options have the highest theta number as well. 
    • Time to Expiration — As time to expiration approaches, options that are close to the strike price see their theta increase significantly. Essentially, as the option approaches its expiration date, it will have a high theta if the underlying stock price is close to the strike price.

Ch. 3: Market Markers, Risk, and the Individual Trader

  • Market Maker — A New York Stock Exchange (NYSE) specialist who “makes markets” by buying and selling stocks and options. Market Makers make money by creating spreads in the bid and ask price for customers. 
  • Managing Risk — With options, Market Makers manage risk by constantly looking at the Greeks. If the portfolio begins to have too much, or too little, of delta, theta, vega, or gamma, the specialist makes a move to rebalance. 
    • Quote (P. 42): “The portfolio should not get too short or long gamma, too short or long vega, too short or long delta at any given time. The market maker manages the ‘portfolio Greeks,’ adding up the amount of delta, gamma, vega, and theta. If one of the portfolio Greeks is too large, the market maker does something about it. A trader may apply the same principles.”

Ch. 4: Volatility

  • Volatility — Considered the most important part of trading options and recognizing good trades. Volatility can be gauged by looking at the VIX, which measures the premium being gathered on S&P 500 Index (SPY) options. When volatility is high, traders are getting more premium on SPY options. When volatility is low, SPY options are producing lower premium. The VIX measures that trend. There are two types of volatility:
    • Realized Volatility (RV) — How much the market is actually moving
    • Implied Volatility (IV) — The amount of perceived movement in the market. It’s the market movement that is expected to happen. It’s what the market thinks will happen in the future regarding movement. 
  • Realized Volatility (RV) — There are four zones that make up realized volatility for any individual stock. Although not the exact same, these four zones also exist for implied volatility (IV). The zones include: 
    • Zone 1 — When realized volatility is very low, options prices tend to be overpriced. This means selling options in low realized volatility conditions is usually the way to go because it means implied volatility (IV) will be higher. In low volatility conditions, the overall market tends to move higher, albeit slowly. Zone 1 is in place when the VIX is 14 or below. 
    • Zone 2 — This zone is characterized by 12-17% movement in the S&P 500 Index (SPX) and is maybe the best zone for selling options because premium is generally a little higher and volatility tends to cool down and go back to Zone 1 levels rather than get worse. This level of volatility usually occurs when there’s a lot of uncertainty in the market. Earnings season and Federal Reserve (Fed) decisions can send the market into this zone of volatility. In Zone 1, stock prices are usually exclusively moving up slowly; in Zone 2, stock prices are moving up AND down. Zone 2 is in place when the VIX is in the 14-18 range.
    • Zone 3 — Volatility moves into Zone 3 when there’s real fear in the market. Zone 3 represents truly high volume somewhere above 22% in the SPX. In this zone, the market is moving 1%-1.5% per day. One of the advantages of Zone 3 is the huge premiums that you can receive when selling options because of the high volatility going on. The tendency in this zone is to head back to Zone 2 or Zone 1 fairly quickly. Zone 3 is in place when the VIX is in the 18-23 range, but it can get as high as 28-30.
    • Zone 4 — This is the panic zone. All hell is breaking lose when volatility hits this zone, which is characterized by volatility of over 30% in the SPX. Because of the extreme volatility in this zone, you’re better off not buying or selling options. There’s too much unpredictability. Wait for things to shake out. Zone 4 is in place when the VIX is over 30. 

Ch. 5: What is Edge?

  • Defining Edge — Edge is exploiting option pricing to take advantage of overly cheap or expensive contracts. To capture edge, traders sell premium when implied volatility (IV) is high, and buy premium when implied volatility is low.
    • Quote (P. 69): “Skills in evaluating realized volatility, implied volatility, and the overall market will enhance your trading skills.”
      • Takeaway — Studying volatility will make you a better trader. Get a good understanding of the volatility going on in the market and what it all means. 
  • Volatility is Key — The key to gaining an edge is volatility. Like the stock market as a whole, each stock has its own level of realized volatility (RV) and implied volatility (IV) that it tends to stay within. But how do you study volatility? There are a few steps:
    • Look at Historical Volatility (HV) — Pull up a volatility chart of the underlying stock and look at the 10, 20, and 60-day historical volatility (HV) lines. This will give you an idea of the relative volatility (RV) going on. 
    • Look at Implied Volatility (IV) — Pull up the stock’s 30-day IV line and study it. You want to identify high and low levels using this chart. The 30-day IV chart is the most important chart to look at to measure implied volatility. 
      • Finding It — Through the Chicago Board Options Exchange (CBOE), you can search ‘VIX’ and enter a stock’s ticker symbol to get this in your phone’s ‘stocks’ app. Only a few stocks are offered, though. Otherwise, most brokerages offer technology tools that allow you to access any volatility chart on any stock.  
    • Decide Zones — Based on the chart and HV/IV lines, decide the ranges of the four zones for that particular stock based on its volatility. Decide which zone the stock is currently trading in. Also determine which zone the entire market is in by looking at a chart of the S&P 500 Index (SPX). Then you can compare the zone that the overall market is in (by looking at the VIX) and the zone the stock you are studying is located in.
      • Quote (P. 67): “If you know the current zone of the VIX, you know the zone of the S&P 500 Index (SPX). For equities, if you know the zone of the SPX, you know the zone of the market.”
        • Takeaway — The VIX tracks the volatility going on in the S&P 500 Index (SPX). By studying the VIX and determining its zones, you know the zones of the overall market, which is key when looking into the volatility of individual stocks. 
    • Decide — Based on your analysis, is there a particular trade with an edge? Based on the volatility charts, you may decide it’s a good time to buy options or sell options.
  • Term Structure — Once you’ve decided that you want to buy or sell options based on the volatility you’re seeing in the stock, use brokerage technology to run a ‘term structure’ report. Looking at term structure will help you decide which contracts and which expiration dates are best. The term structure gives you a good look at the volatility of each specific contract.
    • Quote (P. 64): “The point is that while you might want to collect premium, without looking at the term structure you can’t pick the best spots to trade.”

Ch. 6: Locking in Edge

  • Committing to the Trade — Once you’ve located an edge using the steps discussed in previous chapters, execute the trade by using one of the many option spreads (discussed in Chapter 7). After that, manage the position and close it out if it’s not going well. Don’t hang on to it if it’s a sinking ship. 

Ch. 7: A Review of Basic Spreads

  • Option Spreads — There are several different types of options spreads you can execute. This chapter goes over a few of the most common.
  • Vertical Call Spread — There are two types of call spreads: debit spread and credit spread. When executing one of these, the trader is thinking the underlying stock is going to move up and putting on the spread is designed to capitalize on that movement. 
    • Debit Spread | Bull Call Spread — Buy a call option close to the underlying stock’s current price and sell another call option with the same expiration date at a higher strike price. This creates a spread. Because the option you’re selling is less expensive (because it’s less likely to happen) than the one you’re buying (which is closer to the money and is more likely to happen), setting up this trade results in a net debit to the account. This spread is executed when the trader thinks the stock is going to move up. 
      • Max Gain — Difference in the two strike prices minus the premium paid (when buying the call).
      • Max Loss — The premium paid when buying the call option. 
    • Credit Spread | Bear Call Spread — Sell a call option close to the underlying stock’s current price and buy another call option with the same expiration at a higher strike price. This creates a spread as well. Because the option sold is more expensive than the option purchased, the trader ends up with a net credit to their account. With this spread, you’re thinking the underlying stock is going to stay relatively steady and not reach the high strike price. 
      • Max Gain — The premium received when selling the call option. 
      • Max Loss — The difference in the two strike prices minus the premium received (for selling the call option).
  • Put Spread — There are two types of put spreads: debit spread and credit spread. They have the same goal as call spreads, but are banking on the underlying stock going down rather than up. 
    • Debit Spread | Bear Put Spread — This spread expects the underlying stock to drop. You buy put options just outside the money and sell put options with the same expiration date that are further outside the money. Because you’re buying the put option that’s more likely to happen (closer to the money) and selling the put option that’s further away from the money (and less likely to happen), this spread results in a net debit. This spread wins when the underlying stock’s price drops below the option sold. 
      • Max Gain — The difference between the two strike prices, minus the net cost of the options.
      • Max Loss — Premium spent making the trade. 
    • Credit Spread | Bull Put Spread — Sell put options near the money and buy put options farther outside the money. The expiration dates would be the same. Because you’re selling the option closer to the money and buying the put option further away from the money, this trade results in a net credit. This spread wins when the underlying stock’s price rises above the strike price of option that was sold. 
      • Max Profit — Premium gained
      • Max Loss — Difference between strike prices minus the premium received. 
  • The Straddle — A straddle is set up by either buying or selling both a call and a put on the same underlying stock at the same strike price with the same expiration date. You can go long or short a straddle. These are typically used when a company is about to report earnings. By taking either the long or short position, you are either betting on big movement (long) or very little movement (short).
    • Long Straddle — Buy a call and put option on the same strike price. By buying the options, you’re paying premium. You’re betting on the stock moving a considerable amount, either up or down. You win if that happens, regardless of if the stock goes way up or way down. 
    • Short Straddle — Sell a call and a put on the same strike price. By selling the options, you’re collecting premium. As a result, you’re betting on the stock not moving much. You win if the stock stays relatively steady. 

Ch. 8: A Closer Look at Advanced Spreads

  • Advanced Spreads — There are a number of other spreads advanced options traders use. These can be quite tricky and are recommended to those who are professional day traders. A few of tear include:
    • The Calendar Spread — A calendar spread is an options strategy established by simultaneously entering a long and short position on the same underlying asset but with different delivery dates. In a typical calendar spread, one would buy a longer-term contract and go short a nearer-term option with the same strike price.
    • The Iron Condor — An iron condor is an options strategy consisting of two puts (one long and one short) and two calls (one long and one short), and four strike prices, all with the same expiration date. The iron condor earns the maximum profit when the underlying asset closes between the middle strike prices at expiration.
    • The Iron Butterfly — An iron butterfly is an options trade that uses four different contracts as part of a strategy to benefit from stock prices that move within a defined range. The trade is also designed to benefit from a decline in implied volatility.

Ch. 9: Adding Edge to Spreads

  • Spreads and Edge — You can find an edge when executing option spreads by looking into the following factors:
    • Volatility 
    • Skew
    • Risk Management 

Ch. 15: Trading Volatility

  • The VIX — Often referred to as “the fear index,” the Chicago Board Options Exchange (CBOE) Volatility Index (VIX) tracks expected 30-day volatility in the market by gauging premium received on S&P 500 Index (SPX) options. When premium is high on SPX option contracts, it means traders are expecting a lot of volatility and are wanting to be compensated with more premium. When premium is low on SPX options, it means traders are expecting low volatility and aren’t requiring as much premium compensation. 
    • Inverse Relationship — The VIX and S&P 500 Index have an inverse relationship. When the VIX is high, it normally means the S&P 500 will be down. When the VIX is low, it normally means the S&P 500 is up. 
    • Future Movement — The VIX is a good measure of implied volatility (IV) because it can be thought of as the percentage movement in the S&P 500 that traders are expecting over the next calendar year. For example, a VIX of 25 means that traders are expecting a 25% movement in the S&P 500 over the next year.