The Option Pit Method

Option Pit Boot Camp

The Option Pit Method

For trading options

Option Pit
 Option Boot Camp- The Option Pit Method

- The Option Pit method uses

- Position Structure
- Efficient use of Capital
- Risk Management

- Structure positions that have “edge” but keep the

risk relatively low.
- To do that traders need to know the fundamentals to
identify market conditions
 The Option Pit Method

• “The volatility is in the toilet.” - Mark

Sebastian numerous times on Bloomberg
News

• “If you think education is expensive, try

ignorance.”
― Derek Bok, former Harvard President
Option Boot Camp- What you will learn

• What makes an option move? Intent!

– Inputs and Greeks
• Understanding Volatility Conditions
• Trade selection
• We will cover spreads, collars and butterflies
• Use the Greeks to manage your book
- Intro to risk management
 Boot Camp I- What you will learn

• The Option Pit Input Circle

• The Option Model

• The Greeks – Delta, Gamma, Theta, Vega

 The Option Pit Input Circle
Moneyness
- Which Strike?
Time to expiration
– How Far?
Time Decay
- positive or negative decay
Volatility
– How much does the underlying move?
Direction of the Underlying
- up, down or nowhere fast
The Option Pit Input Circle

What makes an option move?

 Moneyness- Which Strike
• Are the options big dollars or small dollars?
• As the strike price goes from lower to higher
– Calls will go from ITM to OTM
– Puts will go from OTM to ITM
• The more ITM the strike price is, the more it is sensitive to
changes in price
• The further out in time we go, the more the strikes act alike
• The higher the volatility, the more the strikes act alike
• The more ITM the option is, the more cost of carry issues
come into play
 Direction of the Underlying- Price
• Price of the underlying is one of the inputs
that most traders get
– When price goes up, calls gain value
• The lower the strike price, the more value it will gain
from price
• The further out in time one owns the option, the less
sensitive to price the options will be
• The higher volatility of the underlying, the less sensitive
to price the option will be
 Direction of the Underlying- Price

• When price goes down, puts gain value

• The higher the strike price, the more value it will gain
from price
• The further out in time one owns the option, the less
sensitive to price the options will be
• The higher volatility of the underlying, the less sensitive
to price the option will be
Time to Expiration- Expiration Date
• Time is money!

– Small price changes will have little effect on the price

of the option
– Calls and put at all strikes will all head towards being
ATM options
– Options become more sensitive to changes in a stock’s
volatility
– More time, more issues with cost of carry (dividends)
Time Decay- Long or Short Options
• Does the position lose value every day just by
showing up or does it make you money?

-That is time decay

Long options have negative time decay

Short option have positive time decay
 Volatility
• How much does the underlying move?
– That is volatility
• Of all the inputs in the model, this is the only one
we really don’t know
– Interestingly enough, the model is trying to use
‘forward volatility’
– Ends up using implied volatility
• As volatility increases, the value of all options
increases
– Buying insurance before or after a hurricane
 Add the inputs together
• Once all the inputs are accounted for,
investors can start to generate an idea for a
position
• Some of the inputs are easy and some are
much harder
• Look at risk now for the goodies you get
versus the risk of the inputs changing
 Pricing Model Uses Inputs

Inputs
Cost of Carry

Time to
Expiration
Strike

Volatility
Price Theoretical
Value
 What is a Normal Distribution
• Assumes stocks have an equal chance of
moving up or down at any given time
 Variance
• When a distribution moves within a normal
range, it is called a variance
• A variance represents how much we would
expect the data set to vary most of the time
• We use variances all the time as traders
 What is Volatility
• Volatility is another word for the statistical
term variance over a specific range of time
– Represents an expected range for a stock or index
on an annualized basis regardless of direction
• A 75 dollar stock that has a volatility of 20%
– In a given year, the stock is expected to move 15
dollars OR LESS about 2/3 of the time.
– In a given year, the stock expected to move 30
dollars OR LESS 95/100 of the time
 Standard Deviation
• Standard Deviation: annualized volatility over
a non-annual period of time

• volatility*sqrt(days/year)

• Allows traders to connect annualized volatility

into short periods of time
– Allows for use to analyze earnings, events, low
and high vol, you name it
 Standard Deviation Calculation
• SPX Jun 8th 2015 at 2079

– Volatility for the Jul 2 cycle is 15.02%

– Expiration is in 31 days

– So .1502 x (31/365)sq rt =
– 2079 x .043= $91 for roughly 2/3 of the time
 What is Volatility
• There are 3 kinds of volatility we will talk
about:
– Historical Volatility

– Forward Volatility

– Implied Volatility
 Forward Volatility
• How much is a stock moving from RIGHT NOW
until EXPIRATION
– Impossible to gauge
• We are trying to be fortune tellers
– Can use estimates like volatility charts
• Involves overnight risk
• Weekend risk
• Intraday risk
 Historical Volatility
• How much has the stock moved over the last
time period
– High-Low Volatility
– Intraday Range
– Close Close
– Open Open
• 10 day, 20 day, 30 Day, 90 day, 180 day
– I like 20 day because it is has some noise
– Tracks 30 day IV
 Implied Volatility
• We will dig into this more, but:
– Implied Volatility is actually an OUTPUT
• Because it is an OUTPUT, and we do not know
what the stock's volatility is, Implied Vol is
actually an output
• Garbage in, Garbage out
 Implied Volatility
• Issues with implied volatility:
– Because of market fear of a major increase in
forward volatility, option implied volatility is often
too high relative to what ends up being the
calculated forward volatility (we will see this in the
term structure)
– Typically believed to be about 3-4% too high
– Because an instrument may have many strike
prices, hedges or speculations can still be wrong
– The BID-ASK spread in options can throw off IV
 Reversion
• In any given year, an event can cause a security to
have an “outlier” volatility
• But, over time, volatility of any asset will tend to
mean revert
– This means that it will hover around its average
– This applies to all types of volatility that can be
measured
• HV will revert to its mean
• IV will revert to its mean
• FV will overtime BE the mean
 Understanding risk in terms of inputs
• The GREEKS ARE AN OUTPUT of a pricing
model not an input
• As the 5 factors change, so do the Greeks
• The Big Greeks Are:
– Delta
– Gamma
– Vega
– Theta
Easy Greeks
Using the Greeks as a Risk Management Tool
 How to get to P/L

Option Pit FLOW CHART

Easy Greeks- Delta
 Easy Greeks- Delta
• The way an option’s price will move with the
underlying price, sometimes called correlation
• A Positive Delta will move just like stock
– when the underlying rallies, the option MAKES
money
• A Negative Delta will move OPPOSITE of a
stock
– When the underlying rallies, the option will LOSE
money
 3 Definitions
• Change in the option price with a $1 move in
the underlying
• Delta is a hedge ratio
– how many shares of a 100.00 lot of stock that
particular option hedges
• A Loose percentage chance an option finishes
ITM
Delta is a option’s sensitivity to a stock’s
PRICE DIRECTIONAL movement
 Easy Greeks Delta
• Delta has a range of -1.00 to +1.00
– Options with negative deltas negatively correlate
to the underlying
– Options with positive deltas will positively
correlate with the underlying
– The closer the delta is to 1 or -1 the more it
correlates positively or negatively with movement
in the underlying
 Calls and Puts
• Calls have a positive delta
– Buying a call is going long delta
But different positions!
– Selling a call is going short delta
• Puts have a negative delta
– Buying a put is going short delta
But different positions!
– Selling a put is going long delta
Using the Greeks as a Risk Management Tool
Easy Greeks- Gamma
 Gamma
• The simplest definition of gamma is: it is how
delta changes as the underlying price changes
– The measure is how much delta will change with a
1 point move in the underlying
• It is the options sensitivity to a stock’s
MOVEMENT regardless of direction
– Called REALIZED Volatility
 Gamma
• If a trader buys calls or puts, the trader is long
gamma
• If the trader sells calls or sells puts, the trader
is short gamma
– The sign of delta and the sign of gamma have
NOTHING to do with each other
– A trader can be long delta and short gamma
– A trader can be short delta and long gamma
 Gamma
• Long Gamma
– If the position is long gamma as the underlying
rallies, the position will increase in delta
– If the position is long gamma as the underlying
falls, the position will decrease in delta
• Short Gamma
– If the position is short gamma as the underlying
rallies, the position will decrease in delta
– If the position is short gamma as the underlying
falls, the position will increase in delta
 Understanding Gamma

The Small Tent-

The Big Tent- High Gamma
Low Gamma
Easy Greeks- Theta
 Theta
• The simplest definition of theta is: it is the rate
at which an option’s time premium or ‘fluff’ is
disappearing
– How quickly is the ‘insurance value’ heading to 0
• The technical definition is the sensitivity of the
option to the passage of time
• Theta measures TIME RISK
 What is Time Decay
• Time Decay is the difference between an option’s
intrinsic value vs. the option’s extrinsic value
• EXAMPLE: XYZ is trading 28, the 25 dollar call is
trading 5.00 even
– Intrinsic Value: 3.00
– Extrinsic Value 2.00
• At expiration
– Intrinsic Value: 3.00
– Extrinsic Value: 0
 Theta
• A positive theta position will benefit with the
passage of time (as time passes position
MAKES $$$)
• A negative theta position will be hurt by the
passage of time (as time passes position will
lose $$$)
• Long options have negative theta
• Short options have positive theta
Using the Greeks as a Risk Management Tool
Easy Greeks - Vega

Calm seas or rough seas?

 Vega
• The Vega S.A.T. question:
– Delta is to Change in Price as Vega is to:
• White Castle Sliders
• Implied Volatility
• Chevy Camaro IROC-Z
• Cat Nip
• Vega is the change in Profit from a 1 point move
in implied volatility
• Vega measures CHANGE in IMPLIED VOLATILTY
RISK
 Vega
• A positive (+) Vega position will benefit with
an increase in implied volatility
• A negative (-) Vega position will be hurt by an
increase in implied volatility
• Long options have positive Vega (long juice)
• Short options have negative Vega (short juice)
 Vega
• If a trader buys calls or puts, the trader is long
Vega
• If the trader sells calls or sells puts, the trader
is short Vega
• There is a trade off protection against IV
movement vs. collecting premium
– The insurer vs. the insuree
• Think time line as we go into the 5 factors- 60
days, 30 days, 10 days?
Using the Greeks as a Risk Management Tool
 Managing Risk with Greeks
• Managing Risk is about what the trader Does
not know.

– First understand how the Greeks balance against

each other in one position
– How do your positions work together?

• Let’s walk through some examples

 Using the Greeks as a Risk Management Tool

• Delta- Managing the direction of the position

• Gamma- Managing the change in delta
• Vega- Managing the change in volatility
• Theta- Managing the change in time
(dividend)
 Summary
• Inputs move option prices

• Changing inputs move Greeks

• Greeks measure risk and profit and loss

potential
• Use the Greeks to take the risk you want
 Option Pit Boot Camp 1 Quiz

• What is the flow of model inputs to generate P/L?

• Is acceleration a fair way to describe gamma and

what is the market factor most closely associated
with it?

• What is positive Theta? Is it free?

• What is Vega in a position? Please explain.