Many are probably more used to seeing words such as Vega, Rho, Theta, and Delta in the context of fraternities and sororities instead of being central in the pricing and trading of derivatives such as equity options.

For those that do not trade options, that is quite normal.

However, only a small subset of retail options traders understand the mathematics behind how options are valued, such as the “the Greeks”. This lack of fundamental knowledge about risk and return characteristics might start to explain the detrimental impact of option trading on investor performance.¹

The Greeks, a Primer

Delta – is a theoretical estimate of how much an option’s premium may change given a $1 move in the underlying. For an option with a Delta of .50, an investor can expect about a $.50 move in that option’s premium given a $1 move, up or down, in the underlying.

Rho– is a measure of an option’s sensitivity to changes in the risk-free interest rate. It is expressed as the amount of money an option will lose or gain with a 1% change in interest rates. For example, consider a call option with a rho of 0.05; if the interest rates increase by 1%, the option’s price will increase by $0.05.

Vega– is a measure of an option’s sensitivity to changes in the implied volatility. It is expressed as the amount an option’s premium will change for a 1% change in implied volatility.

Theta– or “time decay” is a measure of the change in an option’s value as time passes; options converge to their intrinsic value as expiration approaches.

Video Source: TD Ameritrade

Nevertheless, I often hear new investors say they feel confident wading into options because of tutorials on sites like YouTube and charting tools offered by discount brokerages. Meanwhile, social-media groups with newbie investors swapping stories and self-described experts willing to sell “proven strategies” are (way too) easy to find.

Before purchasing any “proven strategy” or perhaps an indicator that promises “huge” returns – think about this set of logic.

• If one did have the “holy grail” strategy– there is no (rational) person who would give it away (or sell it) because it is only a matter of time before many would quickly arbitrage the method away.
• If one needs to sell a strategy (again that promises outsized returns) – why isn’t the seller focusing their time on using their scheme – especially if it makes them so much money?
• Why would one need to peddle the “holy grail” of trading for $25 to $100 (or some other amount) because that person is already quite wealthy from trading their indictor or strategy?

The answer is greed. Greed by charlatan “trading educators” and self-proclaimed experts, preying on the hopes and trust of inexperienced investors.

The Perfect Storm

Adding to all of this, a growing set of literature presents evidence of further investor irrationality in options markets. Option market investors exhibit the same pattern of short-term underreaction and long-term overreaction to information that has been found in stock markets.³ Also, customers of discount brokers regularly engage in an irrational early exercise of stock options.⁴Additionally, discount broker clients act irrationally by entering option positions that load up on growth stocks a few days before earnings announcements. Even though at earnings announcements, value stocks usually outperform.⁵ Another strand of literature stresses the importance of irrational determinants of individual investors’ trading activity in stock markets, like gambling, entertainment, and sensation-seeking. However, options seem to be more attractive for these purposes than stocks due to the leverage they provide and the positive skewness of their payoffs.⁶ Indeed, a large fraction of individuals’ option activity is motivated by speculation on the direction of future stock price movements.⁷

Preserving Capital with Equity Options

Contrary to the practices noted above, there are ways for retail investors to use options in a manner that may help to preserve capital. One of those ways is to utilize a protective put strategy. A protective put is analogous to the nature of insurance. The main goal of a protective put is to limit potential losses that may result from a decline in an equity price.

Adopting such a strategy does not put a limit on potential profits. The growth potential of equity determines profits from the strategy. However, a portion of the profits is reduced by the premium paid for the put. On the other hand, the protective put strategy does create a limit for potential loss. Profits will compensate for any losses in the long equity position below the strike price of the put option in the option. A protective put strategy is typically employed by a bullish investor who wants to hedge their long equity position.

How does this all work?

Let us say an investor purchased 100 shares of ABC Company (ABC) stock for $10 per share. The stock price increased to $20, giving the investor $10 per share in unrealized gains—unrealized because the shares have not been sold yet. The investor probably does not want to sell their ABC holdings because they believe the stock might appreciate further. They also do not want to lose their $10 in unrealized gains. The investor can purchase a put option against the stock to protect a portion of the gains for as long as the option contract is in force.

In practice, the investor would buy a put option with a strike price of $15 for 75 cents (equity options are quoted differently than the price paid for the option, or premium, as noted below), which creates a worst-case scenario (in theory) of selling the stock for $15 per share. Suppose all things remain equal and the put option expires in three months, and the stock falls back to $10 or declines even further before option expiration. In that case, the investor is protected against any losses below $15. In short, anywhere below $15, the investor is hedged until the option expires (in this case, only three months). The option premium cost is $75 ($0.75 x 100 shares). As a result, the investor has locked in a minimum profit on their absolute position of $425 ($15 strike price – $10 purchase price =$5 – $0.75 premium = $4.25 x 100 shares = $425). To execute this closing trade, the investor would “exercise” the put option by telling his broker (or using an online brokerage account) that he wants to sell stock at the $15 strike price. The premium paid is then recovered, and the stock is sold at $15, well above the market price of $10.

To summarize the exercise of the put option, if the stock declined back to the $10 price point, unwinding the position would yield a profit of $4.25 per share because the investor earned $5 in profit—the $15 strike less $10 initial purchase price—minus the 0.75 cents premium. If the investor did not buy the put option, and the stock fell back to $10, there would be no profit on the stock position. On the other hand, if the investor bought the put and the stock rose to $30 per share, there would be a $20 gain on the trade. The $20 per share gain would pay the investor $2,000 in profits ($30 – $10 initial purchase x 100 shares = $2000). The investor must then deduct the $75 premium paid for the option and walks away with a net profit of $1925.

For the cost of the premium, the investor has protected some of its profits from the trade until the option’s expiry while still participating in further price increases.

In my view, the above strategy is what retailer traders should be learning and focusing on first. The key to building wealth is the preservation of capital. One does not watch a YouTube video and becomes a successful day-trader overnight, let alone a successful options trader. Remember that options are derivatives – and one should be an expert in the underlying (in this case, equities) before even thinking about trading derivatives.

References

¹ Rob Bauer, Mathijs Cosemans & Piet Eichholtz, Option Trading and Individual Investor Performance, (2008).
²J Lakonishok, N Peterson & A Poteshman, Option Market Activity, 20 Review of Financial Studies 813-857 (2007).
³A Poteshman, Underreaction, overreaction, and increasing misreaction to information in the options market, 56 Journal of Finance 851-876 (2001).
⁴A Poteshman & V Serbin, Clearly irrational financial market behavior: Evidence from the early exercise of exchange traded stock options, 58 Journal of Finance 37-70 (2003).
⁵Mahani R & A Poteshman, Overreaction to stock market news and misevaluation of stock prices by unsophisticated investors: Evidence from the option market (2005).
⁶M Grinblatt & M Keloharju, Sensation seeking, overconfidence, and trading activity, Journal of Finance (2008).
⁷Bauer, Cosemans, Eichholtz, supra note 1