Trading Option Greeks
09/02/2008 12:00 am EST
I am sure most of you are aware of the explosion in option trading over the past few years, and most agree that the move to electronic trading and very tight spreads have put an individual option trader on an even playing field with the pros. It should come as no surprise, then, that education in option trading has also exploded. Near the forefront of this growth is Dan Passarelli, who just released his new book, Trading Option Greeks. In this book Dan explains some of the tools that the pros have used for years and those he believes any option trader needs to succeed. Now I should disclose that I have interviewed Dan many times over the past few years, but nevertheless I will do my best to keep my objectivity. I should also admit that, as someone who has traded option for many years, Dan was instrumental in teaching about the greeks.
For those who do not know, the option greeks covered in the book are: delta, gamma, theta, vega and rho. Why should you care? "Option greeks is the term used for the way incremental changes in factors affecting an option price are measured." Furthermore Dan states, "Comprehensive knowledge of the greeks can help traders to avoid common pitfalls and increase profit potential."
If you are serious about expanding your knowledge about options this book will do it, but you will need to take your time reading and studying this book. The first part of the book, "The Basics of Option Greeks" is composed of eight chapters and will give you a basic understanding of the greeks and what role they play in option pricing. Each chapter is full of examples showing how the greeks change with differences in time to expiration, volatility, and the price of the underlying issue. On the most basic level Dan's treatment makes it evident that if you don't understand delta and its value before you purchase or sell an option, you are operating with a serious disadvantage. An important point that Dan makes is that many professional traders use the greeks in option selling strategies that are neutral in terms of market direction. In fact one of the tables he provides breaks strategies into volatility selling strategies and volatility buying strategies. Now quite a bit of the detail may only be appreciated by the serious option trader who already knows something about the greeks, but the novice will be able to glean some of the basics and have a wealth of material for future research.
Part Two of the book concentrates on spreads which are one of the favorite strategies of experienced option traders since controlling risk is a key factor in any trading strategy. This section begins with an in-depth treatment of vertical spreads and explains both bullish and bearish vertical spreads using calls and puts as well as the interrelationship of credit and debit spreads. This is followed by an explanation of the more complex wing spreads that involve multiple options and multiple strike prices. The often-discussed Iron Condor strategy is found in this part of the book. The final chapter in this section deals with calendar and diagonal spreads, with Dan's unique treatment of spreads showing how the greeks influence spreads and which greek is the most important in determining the pricing of the spread.
The last two parts of the book concentrate on the trading of both realized and implied volatility. Speaking for myself, and some of you I imagine, this won't mean much to you until after you have finished the first two sections of the book. If you were not familiar with the greeks before starting Dan's book these sections may be something that you will be ready to apply later on in your option trading career. In fact, the first chapter in Part Three starts off with what he calls 'direction neutral and direction indifferent" techniques. Though I was somewhat familiar with the neutral strategies I had never thought about an indifferent strategy that focuses on "interest and dividends". The strategies covered in the last chapters are more complex and in his conclusion Dan highlights his three-step learning process: Study, paper trade, then showtime. He realistically points out that this three-step process "takes most people between one-and-five years of diligent work to get it right." I know it will take me several more readings to understand some of the concepts discussed in this book but if you are trading options and can't give an accurate definition of the greeks and why they are important, you need this book. Part One alone should help you make much more informed decisions regarding your option purchases and sales.