What Is an Option

From a market practitioner's point of view, options are instruments of volatility. A retail investor who owns a call on an asset, St, may feel that a persistent upward movement in the price of this asset is "good" for him or her. But, a market maker who may be long in the same call may prefer that the underlying price St oscillate as much as possible, as often as possible. The more frequently and violently prices oscillate, the more long (short) positions in option books will gain (lose), regardless of whether calls or puts are owned.

The following reading is a good example as to how option traders look at options.


Wall Street firms are gearing up to recommend long single-stock vol positions on companies about to report earnings. While earnings seasons often offer opportunities for going long vol via buying Calls or Puts, this season should present plenty of opportunities to benefit from long vol positions given overall negative investor sentiment. Worse-than-expected earnings releases from one company can send shockwaves through the entire market.


The big potential profit from these trades is from gamma, in other words, large moves in the underlying, rather than changes in implied vol. One promising name... announced in mid-February that manufacturing process and control issues have led to reduced sales of certain products in the U.S., which it expected to influence its first quarter and full-year sales and earnings. On Friday, options maturing in August had a mid-market implied vol of around 43%, which implies a 2.75% move in the stock per trading day. Over the last month, the stock has been moving on average 3% a day, which means that by buying options on the company, you're getting vol cheap. (Derivatives Week, April 1, 2001)

This reading illustrates several important characteristics of options. First, we clearly see that puts and calls are considered as similar instruments by market practitioners. The issue is not to buy puts or calls, but whether or not to buy them.

Second, and this is related to the first point, notice that market participants are concerned with volatilities and not with the direction of prices—referring to volatility simply as vol. Market professionals are interested in the difference between actual daily volatilities of stock prices and the volatilities implied by the options. The last sentence in the reading is a good (but potentially misleading) example of this. The reading suggests that options imply a daily volatility of 2.75%, while the actual daily volatility of the stock price is 3%. According to this, options are considered "cheap," since the actual underlying moves more than what the option price implies on a given day.1 This distinction between implied volatility and "actual volatility" should be kept in mind.

Finally, the reading seems to refer to two different types of gains from volatility. One, from "large movements in the underlying price," leads to gamma gains, and the other, from implied volatility, leads to vega gains. During this particular episode, market professionals were expecting implied volatility to remain the same, while the underlying assets exhibited sizable fluctuations. It is difficult, at the outset, to understand this difference. The present chapter will clarify these notions and reconcile the market professional's view of options with the directional approach the reader may have been exposed to earlier.2

Insiders Online Stocks Trading Tips

Insiders Online Stocks Trading Tips

We Are Not To Be Held Responsible If Your Online Trading Profits Start To Skyrocket. Always Been Interested In Online Trading? But Super-Confused And Not Sure Where To Even Start? Fret Not! Learning It Is A Cakewalk, Only If You Have The Right Guidance.

Get My Free Ebook

Post a comment