By Lee Lowell
I'd like to begin by addressing some questions and giving my thoughts on various trading activities. Someone e-mailed me about the role of market makers in stock option trading. In my opinion (and I hope I don't offend anyone too badly), the market maker system in stock and stock option trading is unfair and inefficient. There is no outside participation involved with the market maker system. Let me explain. If you're interested in buying ABC stock at $100 and the current market for the stock is $99 bid / $101 offer, you need to wait for the market maker to bring his offer down to $100 before you will even get your order filled. Even though your $100 bid is higher than the market maker's $99 bid, you still will not get filled until the market maker brings his offer down to $100.
When I was trading commodities as a market maker in the crude oil options pit, our method of participation was/is totally different than trading stocks. If the current market for a crude oil $30 call is $0.50 bid / $0.55 offer, you can come in with a $0.52 bid and have that reflected as the best market out there. The screens would then look like this: $0.52 bid / $0.55 offer. You would not have to wait for any market maker to bring down his/her offer to $0.52 in order to get your fill. No matter who you are, if you have the best bid or best offer, your market will be reflected on the screens. The market makers don't control the whole process like it's done with stocks and stock options. This ensures equal participation by all types of traders and leads to tighter markets which in turn decreases the slippage and decreases the monopoly advantage by the market makers.
It seems that the stock market makers have a good thing going for themselves by controlling the markets. I believe that this won't last for too much longer. With the advent of the new ECN's and electronic matchmaking, pit trading is on its way out over the next few years. Time will tell. My only advice for any frustrated stock and stock option traders is to just grin and bear it for right now. Set your limit orders and don't chase the market. If I have given any misinformation, I do apologize and I welcome any e-mails to let me know otherwise.
I have been flooded by e-mails with great questions, mostly asking about volatility. I would just like to sum up a few words about my thoughts on the volatility effect in option trading. I just finished reading a small paperback by Jay Kaeppel called "The Four Biggest Mistakes in Option Trading". He makes a great point in his first chapter. Most option traders put too much emphasis on trying to get their timing right on which way the underlying contract might move. Getting your timing right is an essential part in option trading success, but if you don't do volatility analysis too, your strategy could backfire. Once a trader has determined that the stock is going to go up, they institute the option strategy of "any old call option will do". That's the mistake right there. Are those call options trading at high or low implied volatility levels?
Here's how his example goes: Let's say your bullish on two stocks that just made pullbacks, and you believe they've hit a bottom. You want to buy call options to take advantage of your timing method. What's the implied volatility of each option you're considering? And how does that implied volatility compare to its past levels? If both stocks are trading at $50, and you believe both will go up the same amount, which stock should you pick? That's where your volatility analysis will help. If you want to buy the $60 call on each one with the same expiration, look at the implied volatility of each and then look at the price of each. If one costs $2 and the other costs $4, the choice is easy. The reason why one is cheaper is because its implied volatility is lower. Not only will buying the cheaper one cost you less money to begin with, but you will profit more on your call option if volatility starts to turn higher. If you bought the more expensive one and volatility starts to drop, you could end up losing money even if the underlying stock moves in the direction that you predicted!
I want to expand a little more on the subject of "delta". Every option has a corresponding delta that is a by-product of the Black-Scholes trading model. All ATM options have a delta of 0.50, ITM options have a delta higher than .50 and OTM options have a delta lower than 0.50. The first definition of delta tells us the chance of our option finishing in-the-money. When an option is ATM, its strike price is the same as the price of the underlying stock at that moment in time. If IBM is trading at $100, then the $100 call is ATM. Now this $100 call will be either ITM or OTM on expiration day. Therefore, the delta of 0.50 is telling us that there's a 50% chance that it will expire ITM or OTM. The IBM $50 call is ITM to begin with and has a hypothetical delta of 0.85. This tells us that the $50 call has an 85% of expiring ITM. The OTM IBM $125 call has a delta of 0.10, so there's only a 10% chance of it finishing ITM.
How can we use delta in our options trading? That depends on your degree of risk, speculation, and how much money you can afford. If you're going to take the super speculative route, then buying far OTM options with low deltas are for you. You will probably lose 19 times out of 20, but if you hit a big one, you could be set for life. If you're looking for an option which will closely mimic the moves of the underlying stock and that has smaller time decay, you should buy an ITM option. This will cost less than buying 100 shares of the stock outright, plus you'll get the almost the same amount of movement that the stock makes. Which brings us to the second definition of delta.
The delta of an option will also tell you how much the option price should move up or down in accordance with the underlying's movement. A delta of 0.80 tells us that for every $1 move in the underlying, the option price will move $0.80. If IBM moves from $100 to $101, a call option with an 0.80 delta will see its price move from $2 to approximately $2.75. And if IBM moves from $100 to $98, then this same call option will most likely go from $2 to $0.50.
So I'd say that having a good grasp of how to interpret implied volatility and knowing the delta of each option can give you a good advantage when trading options. Not only will you be informed of whether you're buying an expensive or cheap option (based on past implied volatility levels), but you'll also know how much your option will react in conjunction with the moves in the underlying.