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Risk is a subject one can devote a lifetime to inquire about, and options trading will certainly make up part of that study. Concomitant to survival as an option trader, one needs to be au fait with a number of threats that lay waiting to trap the novice or unwary. Given that survival in order to continue trading is every trader’s paramount objective, the containment of addressable threats is only neglected by the foolish.

Basic option theory reveals that risk is limited when buying options, and unlimited when selling them. The fact that volatility is traded and option positions are hedged does not relieve a trader of this simple fact. Selling options is risky in any language.

Due to this fact, amid the numerous trading opportunities that present themselves around the option markets of the world, those that represent the most value will invariably involve the person benefitting from that value to be selling options. This of course may be in the context of an intricate strategy involving many strikes and types of options, or it can simply be in the form of excessive value being sacrificed by a buyer in order to initiate a position.

The unreflective trader will be presented with this opportunity, and quite understandably react with glee. However, after the value is gratefully accepted, the trader must now convert it into profit. Of course, this can be accomplished by managing the trade, closing it out, or by offsetting the trade through transacting other options.

Still, as the greatest value involves selling options, in the event of additional value opportunities entering the market, that trader will be unable to take advantage of it; they are already fat with risk from previously selling options. In the further event of a large move, the trader may well jeopardize the main objective – survival to continue trading.

In order to avoid this sad turn of events, it will be prudent to affect some insurance beforehand. Bearing in mind that insurance, just like options, comes at a price, the most prudent of insurance will come in the purchase of out of the money protection. Ideally this will be merely a few points for each option, and can be executed efficiently as a combined strangle strategy by purchasing an out of the money put and an out of the money call together at a combined price.

Again, this strategy necessarily means paying away some value in order to be protected, but it will remain an asset that the trader can rely on until expiry. In the meantime the trader will be able to concentrate on trading closer to the money strike prices with larger premiums and greater opportunity for profit. The out of the money options that are acquired will quickly erode to be worthless, but their presence in the portfolio will provide a latent value that only the discerning will appreciate. Trading of at the money options will quickly replenish the insurance expense incurred.

At this point, such a trader is free to exploit the real value in option trading that makes its self apparent. They can participate with confidence as they are protected on either side of the market. In many ways option trading is a constant struggle to emulate one very large and cumbersome butterfly.

Certainly taken with a view to either purchasing the underlying in the foreseeable future, or conversely with a view to the underlying trading in a range tending slightly toward the upside, the practice of selling puts is not as outrageous as it may at first appear. 

If indeed the underlying is going to be acquired, if the market falls the options may be exercised and therefore contrive what was envisaged in the first place – ownership of the underlying. However in this situation the price of ownership has reduced somewhat, and the premium received from the sold options will also offset the purchasing expense.

On the upside, the premium will again be retained and serve to compensate against the now higher price to be paid. Alternatively, the underlying need not be purchased at all; the premium may simply be retained as profit.

 When the market is expected to trade within a range for some time, the practice of selling puts will prove to be lucrative should this indeed be the case. Time value will erode to the benefit of the seller.

 Time value reflecting volatility will be a component in the option price, and so be captured once the transaction is affected. Apart from the fact that markets rise slowly, the fact that they indeed appear to display disturbing momentum when they tumble, is in this scenario used to the advantage of the seller.

Fully aware of the tendency to higher volatility on the downside, equity option markets will invariably adopt a skew that will extend across all strike prices reaching higher volatility as the strike price is lower. This necessarily means that the seller of at-the-money or out-of-the-money puts will receive statistically higher premiums than a normal bell curve of probability will produce. If prices are achieved that are even higher than what the skewed model reveals, then an even greater mathematical advantage accrues in favor of the seller. Considering the historical appreciation that equity markets enjoy by virtue of inflation, enormous theoretical edge is found in the selling of puts.

 While synthetic puts are able to be replicated with covered calls at a par ratio, the volatility reflected in the premium received for sold calls is far less attractive, and so a higher annualized return is possible through selling puts. One consideration that may erode this advantage to some extent is the possibility of dividends accruing through underlying ownership of stock in a buy write strategy. Balanced against the interest expense of purchasing stock, dividends may at times make the covered call the more advantageous strategy.

Additional thought ought to be given to the funding costs of sold puts against that of the covered call. Particularly with the increase in policy and regulation by clearers, the cost of holding uncovered positions will increase exponentially.

Spread trading with options may appear fairly straight forward; even rather attractive due to its risk aversion properties however, as often the case with serious investment; not all is as it seems.

Options like any capital asset are valued according to their future returns, or more precisely, the probability of future returns. According to market perception the forces of demand and supply will manipulate the price of an option, regardless of what a mathematical pricing model suggests.

In this event, the concept of a linear benchmark for annualized option volatility is found to be sorely wanting. Similar to other capital investments whose future earnings are diluted by an increased likelihood of lower spending power, option prices will ultimately be at the mercy of market forces who at times may value the likelihood of returns to be quite at odds with linear projections.

Of course the experience of human nature is of invaluable assistance in this scenario. Many markets behave in precisely the same fashion each time they undergo a uniform shift of similar variety. It is in this observation that spread trading can be maximized to exact value.  As markets rise, volatility often plummets as assets are often far slower to appreciate in value than depreciate. This observation would dictate a spread that leaves the trader with a short volatility position as the market rises. Conversely, markets fall with gusto and so remaining long volatility in anticipation of a downward shift will leave a portfolio long when the market retraces and volatility rises without exception. In these sorts of environments, traders need to apply the above strategy to spread trading around the money. The greater the distance between the strike prices, the greater a skew will develop in the market to reflect various volatility differences between strikes. Mathematically, the skew is irrational as often the trader will pay a higher volatility for the long leg of the spread than receiving for the short leg. However, in reality the trader will profit as mathematics is merely art, whereas market fluctuations and human responses are life. With option volatility, art does not replicate life.

When strike prices are come closer together in spread trading, the skew necessarily needs to reduce; proximity breeds familiarity with options, and so care must be taken to avoid excessive zeal in applying a skew principle. Particularly as the strike prices in a spread strategy approach the at-the-money strike, care ought to be taken to incorporate the volatility consequences of the strategy along with future market inevitabilities.

Weekly options are offering many traders the opportunity to hedge with even more precision. It offers what is typically no more than that of an option with one week to expiry, but if strike prices are thoughtfully available, the concept of weekly options may serve to be more than a mere I week option; it could attract considerable volume from other option markets and even expand net open interest.

Having said this, weekly options by virtue of their brevity, are likely to be the riskiest options available. While premiums are often what newcomers to the option markets find alluring, the slight premium of a weekly option can be elusive.

Again, a weekly option is no different from a 3 month option, a 6 month option, or any other option of longer maturity. Its mechanics are the same, and indistinguishable when entering the last week to expiry. Given this mathematical relationship, arbitrage opportunities may arise if administrative costs will allow.

For the buyer of options, the last week to expiry has traditionally been the best value. Premiums are shamefully cheap, and often the underlying market will move sufficiently to hedge with gusto. Here, the mathematical model indicates considerable vulnerability, for an annualized volatility is the farthest aspect of reality when an option has one week to expire.

With such a short life span, the gamma of an option will experience profound change on many occasions within one trading day.  This of itself will reveal that volatility is invariably found to be too low when an option has one week to expire.

When volatility is increased within the model, the Vega (the premium change for a 1% increase in volatility) will be modest. Volatility will need to be increased dramatically to affect a change of any real magnitude. Of course the delta output from the pricing model will also be altered but similarly, will fail to reflect the precision required for hedging numerous times during one trading day.

For these reasons, many traditional grantors of options will seek to be reverse positions to a relatively flat position in the spot contract about to expire, directing their attention to the following delivery period. Buyers may well experience windfalls due to the dual advantage of short expiry and a vulnerability in the pricing mechanism, but sellers are in direct line for disaster unless sufficient premium is received; but for an option precisely at-the-money, this is rarely the case.

Of course the reason for market volatility in the last week of a contracts life is a moot point. Each moment in the market has reason of its own, but occasionally certain events can trigger an unusual abandonment of one contract in the lead up to expiry, with the entire market focusing its attention elsewhere.

When the tick value of a contract is experiencing transition for example, or if margin requirements have escalated overnight, traders will seek to close out positions and trade an alternative contract. With one week to expiry, the spot option is now a veritable ghost town which may provide some trading opportunities as spreads can widen, and premium can increase sufficiently to satisfy a seller’s criteria.

If you are trading weekly options it will behoove the novice to buy options prior to selling. Without adopting this practice, the sheer weight of gamma will crush the investments of one and all under the most modest of underlying market movements. Short-dated options are exciting, but only for the wary.

Ideally, one ought to wait until value presents itself in an offer. Here acquiring a long position will buffer against the urge to sell weekly options. Of course some traders invest in options with a view to market direction, in which case capturing time premium is not imperative. Even these types of directional traders will benefit from exploiting the pricing model by purchasing options to reflect their market view, rather than selling them in the alternative. With the latter investment offering limited benefit from a successful prediction of market direction, the shortcoming s of the pricing model and also reason dictate that the value and even the most modest of anticipated returns will result in a far more astute investment. Returns on investment vary considerably in modern commercial climates, and those that are imbued with the risk of the financial markets demand a commensurate return. Anything less is foolhardiness.

Of course even the most diligent and conservative of investors will need to remain keenly aware when trading weekly options. Essentially all capital investment is the trading of future returns and so to succeed in the pursuit of trading weekly options, all the ramifications need to be understood well.

Despite the trader investing in long options positions before selling, one’s position can change dramatically as the underlying instrument changes course, and a position that was once long volatility will all of a sudden become short volatility. Essentially, as the market moves away from the area where a trader is long options, profits will accrue when time value has been captured through the device of a hedge in the underlying instrument. These profits however, also have a delta and gamma (or rate of change of profit and rate of change of change of profit). This being the case, the profits accrued from a long position will begin to be offset at an increasing rate, the further away the underlying market gets from the long strike price, and the closer it gets to the short strike price.

To prevent this unfortunate turn of events, the wise will ensure that a ratio favoring the long side will be employed to their trading of weekly options. When this is the case, a residue of long options is retained at all times, where the trader is free to sell a portion of his long option accumulation, and still take advantage of value that presents itself as premiums escalate with volatility.

Spread trading with options may appear fairly straight forward; even rather attractive due to its risk aversion properties however, as often the case with serious investment; not all is as it seems.

Options like any capital asset are valued according to their future returns, or more precisely, the probability of future returns. According to market perception the forces of demand and supply will manipulate the price of an option, regardless of what a mathematical pricing model suggests.

In this event, the concept of a linear benchmark for annualized option volatility is found to be sorely wanting. Similar to other capital investments whose future earnings are diluted by an increased likelihood of lower spending power, option prices will ultimately be at the mercy of market forces who at times may value the likelihood of returns to be quite at odds with linear projections.

Of course the experience of human nature is of invaluable assistance in this scenario. Many markets behave in precisely the same fashion each time they undergo a uniform shift of similar variety. It is in this observation that spread trading can be maximized to exact value.  As markets rise, volatility often plummets as assets are often far slower to appreciate in value than depreciate. This observation would dictate a spread that leaves the trader with a short volatility position as the market rises. Conversely, markets fall with gusto and so remaining long volatility in anticipation of a downward shift will leave a portfolio long when the market retraces and volatility rises without exception. In these sorts of environments, traders need to apply the above strategy to spread trading around the money. The greater the distance between the strike prices, the greater a skew will develop in the market to reflect various volatility differences between strikes. Mathematically, the skew is irrational as often the trader will pay a higher volatility for the long leg of the spread than receiving for the short leg. However, in reality the trader will profit as mathematics is merely art, whereas market fluctuations and human responses are life. With option volatility, art does not replicate life.

When strike prices are come closer together in spread trading, the skew necessarily needs to reduce; proximity breeds familiarity with options, and so care must be taken to avoid excessive zeal in applying a skew principle. Particularly as the strike prices in a spread strategy approach the at-the-money strike, care ought to be taken to incorporate the volatility consequences of the strategy along with future market inevitabilities.

The art of option trading is made ever so much easier by technology with most traders using a pricing model to generate benchmark prices. Of course these prices rely not only upon a volatility variable, but also particular variables not the least of which are the price of the underlying instrument, interest rates, dividends and days to maturity.  The VIX on the other hand seeks to eradicate these additional dependencies by providing an option market that isolates volatility.

When trading ordinary equity option markets or equity index markets, volatility is inherently high but is merely one of the many idiosyncratic influences on investment analysis. Liquidity, open interest and behavioral aspects of the option market will play an equally relevant part in directing a trader’s intuition. Trading the VIX however, appears to relieve the trader of having to factor in contingencies to an option trade that will otherwise need to be addressed in the future. For example, that equity volatility routinely collapses when the underlying market appreciates has always proved to hamper the buying of out-of-the-money call options in a bid to initiate a long volatility position. Similarly, out-of-the-money puts invariably trade at extremely high volatility due to the skew that incorporates the mayhem of a stock market crash. To use these as a method of selling volatility may be mathematically sound however, when the market actually does reach those levels, volatility is redefined to send chills up the spine of the most seasoned trader. In the panic of a major equity collapse it is more a case of survival than calculating volatility. Even more so than the upside counter scenario, the downside volatility contingencies that will be faced will find the most progressive of pricing models most wanting.

Within this framework the VIX provides the perfect antidote. It isolates volatility to be traded alone without the influence of underlying instruments and unique market behavior. As the VIX is an estimate of price movement in the S&P500 of one standard deviation into the 30 day period approaching expressed as an annualized price range. As such the VIX contradicts the premise that an underlying instrument is absent as the VIX itself is the underlying instrument to the options upon it. It is here that volatility is isolated and the trader is free of external influences. Call options on the VIX will be the right but not the obligation to a long position in the VIX i.e. a long position on the volatility of the S&P500. Put options will provide opportunities to implement sold positions in the VIX; the volatility of the S&P500. Regardless of whether S&P500 option volatility moves up or down in response to underlying market movements, the historic volatility in the underlying S&P500 will be determinative of a VIX option position.