One of the appealing features of options is that we can use them to create positions that reflect specific views of the underlying market. If we were limited to trading the underlying we could only express straightforward views such as being bullish (buying the underlying) or bearish (shorting the underlying). With options we can do much more.
In this Article we see how to do this.
When looking for an options strategy, there are three main things to consider:
1. Our forecast of the direction of the underlying.
2. Our forecast of the volatility of the underlying.
3. The amount of risk we are willing to take.
These are not the only considerations. As we have seen, option values also depend on interest rates and dividends, so these should also be considered. However these will generally be of far less importance than the three factors listed so can be taken into account last.
VIEW AND OPTION STRATEGY SELECTION
Bullish Underlying Forecast Option Strategy
If we are bullish we expect the underlying to rise. In this case we want to select an option strategy that profits when the market rises. So these strategies need to be long delta.
Bearish Underlying Forecast Option Strategy
If we are bearish we expect the underlying to fall. In this case we want to select an option strategy that profits when the market declines. So these strategies need to be short delta.
Neutral Underlying Forecast Option Strategy
In this case we either expect the underlying to remain in a tight range or we could have no opinion about the underlying at all. So we either design an option position that profits when the underlying remains range-bound or we are using options for a different purpose altogether. This could be trading volatility, hedging another exposure or implementing an arbitrage.
Volatility Forecast Option Strategy
There are two types of volatility that options traders need to consider: realized volatility and implied volatility. A realized volatility forecast means that we are expecting the underlying’s volatility to behave in a certain way. This forecast is expressed through a gamma position.
An implied volatility forecast is a statement about the value of the options we are trading. This forecast is expressed through a vega position. A simple option position will generally have the same sign in gamma and vega, but this is not always true and the difference between implied and realized volatilities is a crucial one and should never be ignored.
Increasing Realized Volatility Option Strategy
Here we either expect the underlying’s volatility to rise or at least that the underlying will be more volatile than is predicted by the option market. In this case we want to select an option strategy that profits from increased choppiness. These strategies should be long gamma.
Increasing Implied Volatility Option Strategy
Here we expect the implied volatility to rise. In this case we want to select an option strategy that increases in value when implied volatility increases. These strategies should be long vega.
Decreasing Realized Volatility Option Strategy
Here we either expect the underlying’s volatility to fall or at least that the underlying will be less volatile than is predicted by the option market.
In this case we want to select an option strategy that profits from a rangebound market, or when the underlying becomes less choppy (“quieter”). These strategies should be short gamma.
Decreasing Implied Volatility Option Strategy
Here we expect the implied volatility to fall. In this case we want to select an option strategy that increases in value when implied volatility falls. These strategies should be short vega.
Neutral Volatility Option Strategy
In this case we either have no opinion about future volatility, implied or realized, or we are actively of the opinion that it will remain unchanged. These strategies will be both gamma- and vega-neutral.
Risk Tolerance Option Strategy
One of the great appeals (and traps) of option trading is that positions can be tailored to almost any level of risk. However this topic is too nuanced to split into two or three categories. As we introduce each strategy we will discuss the risks associated with it. More generally most of option trading comes down to managing risk, so it would not be an exaggeration to say that option trading is about balancing the risks and rewards of various option trades and strategies.
