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Author: MDCigan Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 11010  
Subject: Options trading methodology Date: 12/4/2000 5:57 AM
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In my quest for continued learning about options, I recently picked up the book Options-Essential Concepts & Trading Strategies which is put out by The Options Institute which is the educational division of the CBOE. Different chapters are written by different authors, but all the authors are experts in options with impressive credentials and educational pedigrees. Many are instructors at the Options Institute. Anyhow, reading through the book, there was some interesting statements and commentary regarding subjects I have seen debated here and elsewhere.

One of the big debates it seems to me is what is the more important aspect of options trading: Is it making the right choice of underlying and associated directional bet or is it making sure all your mathematical quantities of options (IV vs. HV, gamma, theta, vega, etc.) are optimal. Also, of course, the never-ending, eternal debate on the prudence and riskiness of covered calls, buy-write, etc.

Anyhow, the various authors have written on this so lets just jump into the text. Anything in quotes is the author's direct words unless stated otherwise.

Everything from Chapters 2 and 3 were written by James Bittman who formerly was an equity options market maker at the CBOE, and has a MBA from Harvard.

Chapter 2, p. 37, in a discussion of implied volatility:
"For the off-floor user of options, however, differences in implied volatility and recent actual volatility rarely are significant. For the off-floor trader, other factors such as stock selection, timing of price movements, and desired rates of return are more important considerations."

Chapter 2, p. 42-43, discussing gamma:
"The typical individual investor should be careful not to place too much emphasis on this concept. For the typical individual investor, stock selection and market forecasting are, by far, the most important concerns."
Further down the page:
"Gamma has little importance to the nonprofessional or non-market maker who does not carry large and frequently changing option positions."
"Again, this concept is relevant primarily to the professional trader"

Chapter 2, p.47, discussing theta:
"Although theta is a sophisticated mathematical concept (it is the first derivative (slope) of the time line in Figure 2-4), it is valuable to all users of options."

Chapter 2, p.49, discussing vega:
"Again, this is a concept that is most relevant to the professional trader."

Chapter 2, p.56, summarizing the chapter:
"Advanced pricing concepts such as how deltas change, how theta changes, and how changes in volatility affect option prices are important primarily to professional option traders who manage large option positions of both long and short options. The typical individual investor and portfolio manager should be most concerned with market prediction, stock selection, and risk management."

Chapter 3, p.75, discussing option valuation:
"Overvalued and undervalued are terms that are used and misunderstood as often as volatility. A common misconception is that buying undervalued options and selling overvalued options is good. In fact, neither is necessarily good! For example, an investor who purchases an undervalued call can still lose money if the underlying stock declines in price. There are many important factors in option trading decisions, and, frequently, too much emphasis is placed on the misunderstood concepts of overvalued and undervalued."

Chapter 3, p. 77, more on volatility:
"Perhaps the biggest misconception about the strategy of buying undervalued options and selling overvalued options is that, somehow, when an option returns to fair value, a profit will result. Nothing could be further from the truth! Although the volatility estimate is a component of an option's price, a much bigger component is the price of the underlying security."

Chapter 3, p.77-78, more on volatility:
"Although a forecast for changes in implied volatility plays second fiddle to forecasting the change in price of the underlying, knowing about implied volatility may help traders improve results. Rather than focusing on overvalued and undervalued options, traders should be aware of implied volatility levels and how much they can change. Unfortunately, there are no hard and fast rules about what volatility is low and what is high. Knowledge of implied volatility changes should become part of the subjective decision-making process for option traders. There is nothing wrong, per se, with buying a high volatility or selling a low volatility, because price changes in the underlying stock are a far more important factor in option price changes. However, changes in implied volatility may be either the icing on the cake-or the vinegar in the soup: when the trade is completed, the result may be a little bigger or a little smaller because of a change in implied volatility."

Chapter 3, p. 78, summarizing the chapter:
"Very often investors place too much emphasis on trying to buy undervalued options and sell overvalued options. While volatility is an important component of an option's value, the biggest component of an option's value is the price of the underlying stock. Consequently, most investors should concentrate on market forecasting and stock selection, and place less emphasis on forecasting volatility."

Chapter 4 is written by Elliot Katz who was an instructor at the Option Institute teaching option strategy to professional money managers and now is a vice-president at an investment firm.

Chapter 4, p. 79, discussing option strategy:
"Many options investors spend a lot of time acquiring technical knowledge of pricing behavior. This is a worthy goal, but above all, remember that options are derivative instruments. Options cannot exist without an underlying asset. As such, there are only two important factors that direct the investor to the proper strategy. The first and foremost is the investor's opinion of the underlying security. There are strategies to take advantage of bullish, bearish, neutral or uncertain opinion. Any decision made without a specific opinion of the potential movement of the underlying security is unsubstantiated and has a high probability of failure. The second factor concerns the profits the investor desires if his opinion is correct and his willingness to accept any losses that accompany his strategy if his opinion is wrong."

Well, there is more stuff I could cite, but I am getting sick of typing and I'm sure you are probably sick of reading (jeez that was a long post). Besides, I am sure the point has been made. When I first started considering trading options, the point was to leverage my stock picks. As I learned more, I started to appreciate the mathematical quantities more and more. Now I feel like I have come full circle. I think it is correct to incorporate the mathematical quantities into your option trading decisions to get whatever edge possible, but I think they are the trees, and your opinion on the direction of the underlying is the forest. And of course, you gotta see the forest and not just the trees. To borrow the old presidential campaign slogan, "It's the underlying, stupid."

I will post some of the excerpts from the book on covered calls, covered writing, buy-writes, at a later time.
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