TRADING FLOOR SECRETS: When to Avoid Buying Calls
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July 17, 2006
Once the novelty and (un)certainty of the current tete-a- tete between Israel and Lebanon settles down, the markets will as well. What is most likely to occur at the first indication of Lebanon's capitulation is the market (as a whole) will respond with a rally and reduction in volatility as measured by the VIX.
Many looking to play alchemist and turn opportunity into profit will be initially tempted to purchase a straight call option. Logic would dictate that a call, with its unlimited upside potential, will possibly create a larger profit than a spread. Caveat Emptor! (Yes, Mr. Kramer obviously has a new Thesaurus.)
When embarking on the start of my floor trading career, I too was naive and greed got the better of me in these situations from time to time. I watched in amazement as the older and more experienced traders eagerly facilitated my objective by selling me my desire lot of calls.
“They must be crazy,” I thought to myself. “Surely they can see the market is going to close on the highs today? Why are they selling me these options?”
They knew, probably from earlier in their careers, that the volatility in the options was going to collapse. They also knew something I didn't at the time, and that’s that vega is more powerful than delta. My peers profited from my learning experience, and I hope that you too now learn this lesson the easy way.
If you have already lost money with a long call position in a rising market but were not sure why, don't be too hard on yourself. I have a professional floor trader friend who spent nearly two decades on the floors and didn't learn this lesson until after he retired and began trading from home. I watched in amazement as he ignored my advice in October of 2002 and purchased naked calls at the culmination of the Internet stock bubble implosion. Like a bloody car accident, I could not take my eyes of his position.
He went out and purchased calls in an index. The index ran up more than 10% in a month, and he struggled to break even on the trade. His call position only broker even after enough intrinsic value filled the call to let this occur. During the first 9% of the rally he was under water on the trade. Yes, vega is that powerful. Please afford me the indulgence of illustrating this through a “hypothetical” example. Please do not look “XYZ” up as it will only frustrate you and confuse the computer.
Assume the following:
XYZ is trading at $98.
The XYZ 100 call is trading for $3.00
The XYZ 100 call has a delta of .44, gamma of 0.03 and vega of 0.22
Volatility of the underlying is starting at 40%.
Note: We will assume a linear model for adding and subtracting gamma and vega (though slightly off) to make the example more straight forward to understand.
The chart below will illustrate quantitatively how this phenomenon works. The first sectional rows have the current stock price and the percentage move. The second set of data (in rows) is the call price and how it responds as one makes money on delta but losses simultaneously because of vega. The third and fourth set of data is the math of the delta and vega move respectively. 
Explanation
As the stock increases in value, the call will make money because of delta. It has to. Yet, the option doesn't budge much because volatility is also declining. (If the reason why volatility is decreasing is escaping you, please feel free to read my previous articles on the Optionetics archives pertaining to volatility.) The decrease in volatility strips time premium from the options in the form of vega.
What To Do Then?
There are many excellent strategies you can implement to potentially profit from a market advance when volatility is high. You can put on a bull put spread; a bull call spread will not perform as well as the bull put spread, but it too can do well if the advance is strong enough. A short-term directional call spread is also an excellent means of taking advantage of this if you’re careful not to allow the net vega of the position get too large. An upside broken wing butterfly is also ideal in these situations as the larger volatility allows one to widen out the distance between the butterfly's strikes further than normal.
In other words, the fact that volatility is high does not prevent on from capitalizing on an advance in the markets, but a straight call purchase is usually not the ideal situation. Hopefully you can learn from this article so that you will not have to learn with your capital. That is our goal at Optionetics.
Good luck and good profits.
Scott Kramer
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site
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