The importance of Greeks
- Thread starter chad_17
- Start date
"I'd really appreciate some examples buddy .. cheers."
Sure. First let's agree that there are many option strategies. In the interest of my time and the space available, I'll focus on just one. Stock replacement. Now the typical armature will go out and buy a fist full of OTM (out of the money) options. However, buying ITM (in the money) with a delta of around 80 will give you a nearly 1 to 1 correlation with the underlying stock for around 25% of the capital outlay.
With just this one adjustment and by knowing the delta's of the strikes you will be able to place yourself in the sweet spot, preserve capital and reduce the risk of holding overnight.
Now if you want to really kick it up a notch, learn the effect of gamma and theta on delta. It will help you a great deal with spreads.
GL
BTW, ever have a stock move your direction and lose money on an option? You just got gamma-ed.
Sure. First let's agree that there are many option strategies. In the interest of my time and the space available, I'll focus on just one. Stock replacement. Now the typical armature will go out and buy a fist full of OTM (out of the money) options. However, buying ITM (in the money) with a delta of around 80 will give you a nearly 1 to 1 correlation with the underlying stock for around 25% of the capital outlay.
With just this one adjustment and by knowing the delta's of the strikes you will be able to place yourself in the sweet spot, preserve capital and reduce the risk of holding overnight.
Now if you want to really kick it up a notch, learn the effect of gamma and theta on delta. It will help you a great deal with spreads.
GL
BTW, ever have a stock move your direction and lose money on an option? You just got gamma-ed.
First thing to keep in mind when making any adjustments is that there's no magic wand that would turn a losing position into a winner. So if you have a bull call vertical and the stock is trading near the lower strike then it's a loser (well it depends on where exactly it trades and how much you paid for it, but for the sake of the argument). There's no adjustment that will make it a winner.
The second thing to keep in mind is that an adjustment is really a new trade so you have to evaluate it as such. In other words, always ask yourself whether you would intiate such a position if you had no previous position. (Here's a tip: if you are trying to adjust a loser then in most cases you will find yourself in a poor risk/reward position. That is, you are better off taking a loss and moving on to new trades where you can achieve better risk/reward ratios.)
Chad,
Well, you are asking pretty good questions for "still a beginner."
I'll try to explain in a different way here. The probability is not sufficient information to tell you what the expected return (the average return over a large number of trades) is. It is necessary to also take into account the amounts of all possible wins and losses.
Suppose you have a so-called 80% iron condor that you are going to hold to expiration. Suppose it has 10 points between the longs and the shorts (I'm just making up some numbers here) and you get 2 points for it. You may tell me that you have an 80% probability of making 2 points if you hold it to expiration, and I agree. However, if holding to expiration, you also have about a 20% probability of losing 8 points.
To get the expected (average) return over a large number of trades, which is what you really need to know, multiply all the probabilities by their respective payoffs and add them up:
prob of win*payoff of win + prob of loss*payoff of loss
(0.8 prob of win)*(2 point payoff) + (0.2 prob of loss)*(-8 point payoff) = 1.6 - 1.6 = 0
So far I have ignored the fact that there is a small area between the short and the long where your return at expiration lies between +2 and -8. But, if you add up the products of all the payoffs and probabilities along that portion of the graph, they will also sum to zero.
I'm just saying that this is true for all these trades, *if* held to expiration, which is only another way of saying that options tend to be reasonably fairly priced. Therefore it behooves you to do something besides blindly hold to expiration, whether that is make an educated guess about volatility and/or skew in the first place, spread positions across different strikes, adjust at opportune times, use insurance, exit if you have a decent profit and there is little to be gained by staying in, exit if something crazy is brewing with the fundamentals, etc.
I don't trade very many verticals, so unfortunately I don't have a suggested adjustment for you. I am sure others can chime in who know more about how to do that.... and good luck.
Any time you adjust, you are giving something else up, and you need to see what that something is. Someone here turned me on to Paul Forchione's books. You may find them helpful for adjustments.
Funny you should ask this question. I use the greeks to determine what option strategy I am going to use. If volatility is rising, then all option prices rise, independent of the direction of the underlying. If volatility is decreasing, then option prices decrease. So, if volatility is in fact decreasing, then "credit" iron condors make money despite the direction of the underlying. Iron condors have negative vega, so they benefit from decreasing volatility. If volatility is rising, then I may choose a long straddle, for long straddle has positive vega. You can, as you said, do no adjusting and HOPE. Or you can make some moves to improve your profitability. Or you can chose a different option strategy based on your analysis of volatility. But, the greeks really don't matter after hosing, unless you want, for instance, a delta neutral position. Then, you need to make frequent adjustments to stay neutral.
I always appreciate that little extra sense of security.