Simple option trading question...

[blueplayer]

Can you kindly explain this point.

Thanks.

When playing long gamma (long options) we want to have maximum optionality (that is we want to pick options with high gamma values) for the period of time of the move we are considering. Unfortunately gamma becomes smaller and smaller the farther we go in expiration time. So as we pick options with long dated expirations, we are giving away the only cool thing options have going on on the long side (gamma). Not only that, you are giving away gamma in exchange for vega risk (which gets bigger and bigger the farther you go in expirations). That is not an ideal situation to be (unless of course the whole point of the trade was to go long vega).

Just play with the optimizer and use different time frames and you will see the effects on returns and RR.

 

[ironchef]

When playing long gamma (long options) we want to have maximum optionality (that is we want to pick options with high gamma values) for the period of time of the move we are considering. Unfortunately gamma becomes smaller and smaller the farther we go in expiration time. So as we pick options with long dated expirations, we are giving away the only cool thing options have going on on the long side (gamma). Not only that, you are giving away gamma in exchange for vega risk (which gets bigger and bigger the farther you go in expirations). That is not an ideal situation to be (unless of course the whole point of the trade was to go long vega).

Just play with the optimizer and use different time frames and you will see the effects on returns and RR.

Thanks for sharing the optimizer. I did play with it prior to asking you about your comment. It seemed to me that the short duration trade had higher return but also higher risks: probability of going negative whereas longer duration had higher probability of positive profit. So, if one does not hold the contract to expiry, one is better with longer duration?

 

[blueplayer]

Thanks for sharing the optimizer. I did play with it prior to asking you about your comment. It seemed to me that the short duration trade had higher return but also higher risks: probability of going negative whereas longer duration had higher probability of positive profit. So, if one does not hold the contract to expiry, one is better with longer duration?

I'm glad you played with it, One piece of information that the optimizer provides is the Risk Reward factor (you can select it from the type of plot). That will tell you what is the best trade for the risk you are willing to take. In general if you think that the expected move will occur pretty soon, you will see that short dated options have very good RR numbers (often exceeding the linear risk reward from the trade).

From the simulations and real life experience if you are playing for an imminent move (1 or 2 days), options with 14+ days on them are very good.

 

[El OchoCinco]

But when I used BS to calculate the percentage change in option prices, using the same (small percentage) delta changes in moneyness (d Call Premium/d Moneyness) and keep all other parameters the same, OTM had higher percentage movements than ITM. Which means if I don't hold my position to expiry, I have a better chance of exiting my position with higher profit with OTM than ITM?

I tihnk this is the trap many traders fall into. An OTM option is $0.50 so if it moves $0.10 then it has a huge % movement versus an ITM option at $6.00 that moved $0.60 (hypothetically). OTM options also depend how far OTM we are talking here. OTM with a delta of .2 to .1 will make a greater % move because they are so low priced but that does not make them the better choice. People are attracted to the $0.50 option because it is cheap and if stock moves they can make a lot but while delta is .1 for example, theta could be .08. Two forces working against each other unless the stock really makes a strong move.

What is a higher profit. If stock moves $2, my ITM call (delta .8) will make more money than my OTM call (delta =.2) assuming you buy 10 contracts of each holding all other things constant. Let us not be tricked by % change. Now if you are saying you will put $1000 in each for comparison, then the the OTM might make more money but over the long term the OTM options will lose more decay than delta gains unless you are amazing at picking 100% big movers each time to profit on .2 delta options, which is rarely the case.

So the choice of ITM, ATM, OTM depends specifically on the situation in that case of how far you expect the underlying to move and in what time frame. There is no general approach. Consistently buying OTM options month in and month out (deltas .1 - .2) is a long term losing strategy since you are making a constant prediction that the underlying will move significantly enough so that delta overcomes theta, without considering vega at the moment.

 

[ironchef]

What is a higher profit. If stock moves $2, my ITM call (delta .8) will make more money than my OTM call (delta =.2) assuming you buy 10 contracts of each holding all other things constant. Let us not be tricked by % change. Now if you are saying you will put $1000 in each for comparison, then the OTM might make more money but over the long term the OTM options will lose more decay than delta gains.

That was my point but I did not understand the second part about losing more to time decay. Can I calculate that from the BS formula?

Thanks.

 

[blueplayer]

That was my point but I did not understand the second part about losing more to time decay. Can I calculate that from the BS formula?

Thanks.

If you are using a pricing engine (like BSM) then all of those things are taken into account for you when you price the move (just decrease the time to expiration by the time that the trade will be open).

 

[blueplayer]

I tihnk this is the trap many traders fall into. An OTM option is $0.50 so if it moves $0.10 then it has a huge % movement versus an ITM option at $6.00 that moved $0.60 (hypothetically). OTM options also depend how far OTM we are talking here. OTM with a delta of .2 to .1 will make a greater % move because they are so low priced but that does not make them the better choice. People are attracted to the $0.50 option because it is cheap and if stock moves they can make a lot but while delta is .1 for example, theta could be .08. Two forces working against each other unless the stock really makes a strong move.

What is a higher profit. If stock moves $2, my ITM call (delta .8) will make more money than my OTM call (delta =.2) assuming you buy 10 contracts of each holding all other things constant. Let us not be tricked by % change. Now if you are saying you will put $1000 in each for comparison, then the the OTM might make more money but over the long term the OTM options will lose more decay than delta gains unless you are amazing at picking 100% big movers each time to profit on .2 delta options, which is rarely the case.

So the choice of ITM, ATM, OTM depends specifically on the situation in that case of how far you expect the underlying to move and in what time frame. There is no general approach. Consistently buying OTM options month in and month out (deltas .1 - .2) is a long term losing strategy since you are making a constant prediction that the underlying will move significantly enough so that delta overcomes theta, without considering vega at the moment.

In general playing long term moves with options is always a losing proposition. There is very little optionality in far dated expirations and more vega risk.

For short term plays ( days), OTM options almost always beat ATM ones both in percentage return and risk reward.

 

[El OchoCinco]

In general playing long term moves with options is always a losing proposition. There is very little optionality in far dated expirations and more vega risk.

For short term plays ( days), OTM options almost always beat ATM ones both in percentage return and risk reward.

Well I am not advising what anyone should do, but you need to clarify what you mean by OTM because I can think of many examples where your statement is false, such as a few strikes OTM and the stock moves higher over the last 5 days of expiration but never gets to the OTM strike. Theta will erase any gains over delta.

This is the problem I highlighted initially that we cannot offer any advise without knowing the magnitude of the expected move. It is wrong to say OTM always beat ATM options. There are no absolutes in options and saying so implies a lack of understanding of the relation between moneyness and the greeks.

You cannot just look at percentage unless you always put the same $$ no matter the moneyness of the options and OTM options are cheaper for a reason (far OTM). So if you consistently trade FOTM options you will consistently lose money. Don't forget you have to be right about the underlying direction and you are assuming you are 100% right.

One can play long term moves with options, it is wrong to see it is a losing proposition. Far dates options means what to you. I have traded, as many other people, options dated 2 months to 5 months out. More vega risk also means more vega benefit since further out in time options have higher vega. It is not a full risk if you take IV into account when you buy them.

Bottom line, I cautioned the OP about asking a question about generalities and your answer is based on the same underlying error.

Far date options such as LEAPS can present much lower risk than owning a stock outright if you use ITM options with delta in the .8 to .9 range. Options using 3 to 6 month expirations can gain on vega if you find relatively low IVs when you get in.

 

[blueplayer]

Well I am not advising what anyone should do, but you need to clarify what you mean by OTM because I can think of many examples where your statement is false, such as a few strikes OTM and the stock moves higher over the last 5 days of expiration but never gets to the OTM strike. Theta will erase any gains over delta.

This is the problem I highlighted initially that we cannot offer any advise without knowing the magnitude of the expected move. It is wrong to say OTM always beat ATM options. There are no absolutes in options and saying so implies a lack of understanding of the relation between moneyness and the greeks.

You cannot just look at percentage unless you always put the same $$ no matter the moneyness of the options and OTM options are cheaper for a reason (far OTM). So if you consistently trade FOTM options you will consistently lose money. Don't forget you have to be right about the underlying direction and you are assuming you are 100% right.

One can play long term moves with options, it is wrong to see it is a losing proposition. Far dates options means what to you. I have traded, as many other people, options dated 2 months to 5 months out. More vega risk also means more vega benefit since further out in time options have higher vega. It is not a full risk if you take IV into account when you buy them.

Bottom line, I cautioned the OP about asking a question about generalities and your answer is based on the same underlying error.

Far date options such as LEAPS can present much lower risk than owning a stock outright if you use ITM options with delta in the .8 to .9 range. Options using 3 to 6 month expirations can gain on vega if you find relatively low IVs when you get in.

I didn't intend my answer to be vague sorry about that, in fact I even posted a long gamma simulator that shows this effect in great detail and allows the person to play with different durations and moves.

Of course the statement should not be constructed as every single OTM strike will always have a better return and risk reward the only ATM strike. I meant to say that for short trade duration a well chosen OTM strike will outperform an ATM one.

 

[blueplayer]

One can play long term moves with options, it is wrong to see it is a losing proposition. Far dates options means what to you. I have traded, as many other people, options dated 2 months to 5 months out. More vega risk also means more vega benefit since further out in time options have higher vega. It is not a full risk if you take IV into account when you buy them.

Bottom line, I cautioned the OP about asking a question about generalities and your answer is based on the same underlying error.

Far date options such as LEAPS can present much lower risk than owning a stock outright if you use ITM options with delta in the .8 to .9 range. Options using 3 to 6 month expirations can gain on vega if you find relatively low IVs when you get in.

This is an interesting point to discuss and we can engage on it if you desire so.

I advance the thesis that playing long "gamma" with long dated options is inefficient, as (for me at least) the only reason I would take extra risks in options is to enjoy optionality. And because long date options have little to no optionality at inception (gamma is basically zero) then I don't see the point of using them at all. It kind of defeats the point of doing gamma trading when gamma approaches zero.

That being said, long date options are less risky than the underlying, but that doesn't mean that they are efficient vehicles at least for gamma trading.