Options are robust securities that allow traders to expand their ability to generate returns far beyond traditional long and short strategies.
For example, options can be used to generate returns even when a trader expects no movement in an underlying. In fact, this is the preferred behavior of a short premium position.
No matter your own unique approach, it's likely the addition of options in your trading arsenal will improve your ability to effectively express your opinion on the markets.
For example, if you are a long-term holder in a particular security, but you are expecting it to sit still (or move lower) in the near term, you can sell a covered call to generate additional return.
There are many other ways that options can be used to express a market assumption, and an understanding of the P/L drivers in options trading can help expand your vision for the product in your portfolio.
As highlighted on a recent episode of Best Practices, there are three factors that contribute to the profitability of an options trade:
Underlying price action (delta)
Time decay (theta)
Volatility change (vega)
When crafting a potential position structure, it's critical to consider the impact of these three factors before deployment.
Underlying Price Action (Delta)
First, let's consider underlying price action, because it is the most similar to traditional long/short investing. Simply stated, a given options position may be exposed to directional movement in the underlying.
Prior to deployment, a trader must, therefore, decide if he/she accepts this directional exposure, or if he/she would alternatively prefer to hedge it off through a "delta neutral" approach.
When trading delta neutral, the underlying security is bought or sold at trade deployment to reduce any delta bias inherent in the options structure.
For example, selling a call spread will result in short delta exposure. A trader can theoretically reduce this directional exposure by purchasing stock at the same time the spread is deployed.
Obviously, the P/L of a position that possesses directional bias will be affected by movement (either positively or adversely) in the underlying. Traders need to design the structure of the position such that the delta exposure of the trade meets their outlook and expectations.
For more information on delta neutral trading, and the potential effects of directional exposure on P/L in options positions, we recommend reviewing this blog post.
Time Decay (Theta)
Another important element to consider when trading options is the P/L impact of time decay.
Options have a finite life. When you buy or sell an options contract, you know exactly when your long or short exposure ends. Importantly, options lose value as the date of expiration approaches, which is commonly referred to as “time decay.”
This concept is easy to conceptualize when one imagines the relative values of two option contracts that posses all the same characteristics - except that one has a week until expiration, while the other has a year to expiration. Obviously, the premium in the latter contract will be much higher.
When selling options, volatility traders are generally hoping to capture time decay as time passes. Alternatively, long volatility traders are banking on a big move in the underlying prior to expiration.
The slides below from Best Practices summarize the P/L impact from time decay on both short premium (positive theta) and long premium (negative theta) positions:
As you can see from the images above, theta also plays an important role in determining the ultimate P/L of a position. In this regard, it’s absolutely critical to match your outlook with the appropriate type of theta (paying or collecting).
Volatility Change (Vega)
The third driver of P/L in a given options trade is the volatility component, often referred to as “vega.”
Knowing the vega of a particular option, or a spread, tells a trader how much they will theoretically make or lose if implied volatility moves by 1%.
An important consideration relating to vega is that it becomes much more relevant as you increase the duration (time to expiration) of an options contract. For example, an option with one day until expiration possesses virtually zero vega. Alternatively, options with several months until expiration have much higher vega.
In practice, that means the theoretical value of a longer-dated option can change significantly, even if the underlying price doesn’t move at all - through moves in implied volatility.
For example, imagine a company announces that in several months they will release an important new product on the market. Under these circumstances, the company’s stock may remain static on the day of the announcement, but out-month options that cover the new product’s launch may see an increase in implied volatility.
In general, buyers of options are long vega, and benefit when implied volatility goes up. Sellers of options are short vega, and benefit when implied volatility goes down.
Putting It All Together
While options are dynamic and add a lot of flexibility to our portfolios, they are also complex and must be deployed with great care.
Prior to trade deployment, traders need to ensure that the delta, theta, and vega components of a given position match their outlook and risk profile.
Forecasting the expected P/L of a potential position by running it through a variety of delta/theta/vega scenarios (spanning best and worst cases) is a great way to ensure you are deploying positions that are suitable for your trader profile.
If you have any questions about the primary P/L drivers when trading options, we hope you’ll reach out by leaving a message in the space below, or by contacting us directly at email@example.com.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.