The world of options trading is filled with vivid descriptions of positions and risk. Butterflies, condors, delta, gamma, beta....it seems to highlight the richness of these tools and their flexibility in which traders can use them for profit and protection.
To cover the incredible diversity and complexity of options in one issue is impossible, but this month we’re covering as much of the options world as we can. And it’s a world that’s getting bigger.
The growth of these products illustrates the importance they have to the financial and commodity business and highlights the diverse and intense interest by professional and individual traders alike in using them to adjust portfolios, hedge risk and take outright positions. Options on equities have been around for decades, but just in the last 10 years the growth of these products and the addition of options on OTC forex has grown sixfold, with more than 1.5 billion contracts traded in 2005 in the United States. Options on futures were launched in 1982, with 117,350 being traded. In 2005 almost 370 million contracts were traded in the United States alone. Options on interest rate futures contracts is the lion’s share of that, while on the equity side the most active options trading is on individual equities. This isn’t counting the latest in trading tools: options on exchange traded funds.
So why the vast interest in these trading tools? The growth of options has mirrored the growth of futures trading; further illustrating the hunger for using derivatives to make and protect money by all levels of traders. A significant portion of options on equities trading is buying calls. Individuals use the tool to take a relatively cheap position in the market, while institutional traders will use them in portfolio strategies to manage cash. Many big players also write covered calls, which is selling calls on the underlying, which they own. It’s a way to make incremental income on a stock position, and risk is limited because the underlying is owned.
As we highlight in several articles covering options trading strategies options trading can be simple, but usually it’s very complicated. (See Futures’ “Options strategies and when to use them,” special pullout poster, “The options dilemma,” page 34, “Freeze season can be option-writing season,” page 38 and “Are options writers due for a fall?” page 62). Futures trading is relatively easy compared to the three-dimensional world of options. With options, it’s not just a purchase price, but the strike price you purchase and the time decay of the position. All these factors are reflected in Greek letters, such as delta, gamma, beta.....and more. With options on equities, the underlying product is the actual stock, while with options on futures, the option is on the futures contract. If it goes to expiration, the futures contract would be delivered.
Although options are integral to the world of trading, long-time traders have seen those who thought they understood the Greeks get hammered. Back in the mid-1980s, a small clearing firm on the Comex, Volume Investors Corp., introduced the world to the dangers of selling far-out-of-the-money options. Back then, there wasn’t any type of margining on those options, and three Volume customers made money by selling calls in a falling gold market. But one gold price spike later, all hell broke loose. Careers were ruined, fortunes lost, customer money frozen and the industry woke up to the real world of options margining. Even today all traders need to be educated to the risks of options writing; but with the proper instruction, options are an invaluable part of any trader’s toolbox.
