In part 1 of this series, I described the main ways options are used (income, protection, favorable stock entries and diversification) as well as how they compare to stocks, risk-wise. Now, let’s talk about the biggest misunderstandings people have about options.
First, people tend to learn just one strategy and then incorrectly assume the characteristics of that strategy apply to all options strategies. This is a natural mistake since the potential decisions for expressing a view on a stock are pretty simple for most people — “do I buy it (bullish), or not?” However, by combining multiple options into one trade (referred to as “spread trading”), you can design many other ways to potentially profit or protect. With options, you can express many other convictions on an underlying than you can with a stock. In other words, it’s not as simple as “do I buy it, or not?”
For example, a lot of people have heard of a “covered call” strategy, as it is a usually the first strategy they learn. This strategy can be very useful in certain situations and easy to manage, as far as options go. Unfortunately, it’s neither appropriate at all times, nor always the best use of capital. Oftentimes, there are simply better strategies to use than a simple covered call. Some people will tell you covered calls are the best thing since sliced bread, and others will only speak of their drawbacks. The truth is that both are correct, to an extent. In some situations, there are literally zero drawbacks to a covered call strategy, but in other situations, the drawbacks outweigh the advantages.
Think of options strategies like automobiles. Asking if a covered call is good or bad is like asking if a snowmobile is good or bad. The answer is that it depends on the terrain, weather and a few other factors. Need to drive up a snow-covered mountain in Colorado in February? A snowmobile is exceptional! Need to drive to work in Texas in July? The snowmobile is a horrible choice! Just like you can drive a sedan in Dallas in July, then rent a snowmobile in Breckenridge in February, you choose options strategies that are appropriate for the current situation. There are many different options strategies, and they each have different characteristics that make them more or less suitable for certain client situations or certain market environments. It’s a very common mistake to get hung up on just one strategy and try to force it on all market conditions.
Second, people often incorrectly assume that “complex = risky,” and “simple = conservative.”This couldn’t be further from the truth. A simple trade can be very risky, while a very complex trade can be very conservative — and vice versa! Further, a stock trade can be more or less risky than an options trade.
Third, they think it is all about direction of the underlying. In part one, I mentioned the price of an option is partially dependent on the price (or price change) of the underlying investment. In other words, the price of an option is partially dependent upon the degree to which the underlying goes up, down or sideways. What does the rest of the price depend on? The Greeks. If you are hiring someone to manage your options trading, it’s not even necessary to know the Greeks exist, so feel free to skip past the following brief intro and onto the next section. However, anyone managing options trades better have a thorough understanding of the Greeks!
“The Greeks” is a term that collectively refers to different ways you can theoretically measure an option’s sensitivity to changes in other quantifiable factors. Without understanding the Greeks, you cannot truly understand the potential risk and reward of an option trade. The four most important Greeks are Delta, Gamma, Vega and Theta. Delta measures an option price’s sensitivity to movements in the direction of the underlying. Delta is neither constant nor linear — it changes based on a variety of factors. Therefore, we have Gamma to understand the rate at which Delta changes. Vega measures sensitivity to volatility, which can also change. Theta measures the option price’s sensitivity to the passage of time. Vega and Theta are what I call the “insurance Greeks” because the way they influence an option’s price is much the same as how the same factors influence the price of insurance.
Let’s take term life insurance, for example. Would you expect to pay more for one year of insurance, or for five years of insurance? Obviously, you pay more for the additional time. Same goes for Theta. Part of an option’s price comes from the amount of time left until it expires, as all options expire.
Staying with the term life insurance example, who would you expect would pay more for a 20-year policy based on the information provided: Bill the motorcycle racer or Steve the accountant? Obviously, we expect Bill to pay more because his lifestyle has a much higher degree of uncertainty than Steve’s does. Same goes for Vega. The more uncertain the market perceives the price of the underlying, the higher its volatility is expected to be. Therefore, one option might have more Vega than another.
A lack of awareness or understanding of the Greeks is the main cause of confusion around options. For example, volatility (read: Vega) can go up even though the price of the underlying doesn’t move (read: Delta). And, a stock can move up like you expected (read: a positive Delta move), but the volatility falls (read: Vega), therefore what you lost on Vega could overwhelm what you gained on Delta! With stocks, being right on direction is the main thing. With options, it’s simply much more complex. That complexity in the hands of a seasoned options advisor can potentially reduce risk and/or provide an enhanced income stream on either a fully invested portfolio or cash.
In part three of this series, we’ll cover the biggest reasons people lose money trading options!
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