Triple 3-Dimensional Options Are

Often I am asked: “What is the advantage of trading options versus trading equities?” In Yoda’s (the Star Wars character) speech pattern, I frequently reply: “Triple three-dimensional options are.” The following article will describe in detail each of the three areas that make the options 3-D when compared to equities.

First of all, it is repeatedly mentioned that options are complicated. I personally dislike the use of the word “complicated” in the same sentence with the word options. The word “complicated” carries within itself assumptions that options are impossible to be learned. In my humble opinion, options are indeed complex but they are NOT complicated. They are mathematically accurate and manageable as long as one has the knowledge of the six grade level of math. I would assume that any reader of this article has completed elementary education; therefore, I could further argue that everyone is capable of grasping how the options work. However, whether a trader embarks on the journey using options as his or her trading instrument is just a matter of perspective. A majority of novice traders find the stock market to be challenging enough and they do not want to embark on more challenges by turning their attention to learning about options. For those rare individuals who do wish to gain knowledge of options, I salute you; it is for you that I am writing this article.

Options aren’t complicated, they are simply complex. Options are all about choices. Choices aren’t complicated they are just numerous and that is the beauty of it.

The first main difference between trading the equities versus options is in the direction. When trading equities there are only two choices possible when opening a position: to buy or to sell short. In either way, one has to be correct about the direction in order to receive money from the market. Nonetheless, the market can move in more than two directions – it can go sideways, too. The table below illustrates the point of having two choices versus three possible outcomes.

Trader’s choice	Market went up	Market went down	Sideways Market
Long	Profitable	Not	Not
Short	Not	Profitable	Not

In other words, the probabilities of being profitable with equities are only 33.3% which is worse than flipping a coin. In short, an equity trader could not become profitable when the market goes sideways. If the possibility of the market going sideways gets removed from the equation, then the equity trader has a 50-50 chance.

Options, on the other hand, could produce income no matter which direction the market goes: up, down, or sideways. The equities trading could make some profits only if the open position moves either up or down. There is no in-between scenarios for the equities being profitable if the market goes sideways. Unlike the equities, there are options strategies which are specifically designed to be profitable if the stock market goes sideways. One of those neutral strategies is Iron Condor, a combination of two vertical credit spreads. It is the range of the underlying that needs to be selected accurately for a specific amount of time and as long the price action stays within the boundaries of that predetermined range, the time constrained Iron Condor would be profitable.

Having described a single dimension, the direction, I shall revisit my argument that options are 3-dimensional instruments. Once again, an equity trader is always a directional trader; whereas an option trader could be more than just a directional trader. In the example above with the Iron Condor strategy, an option trader was a non-directional trader.

In this second segment, I shall use an example of an option trader who is a directional trader, and he or she wants the market to go either up or down. In other words, I am comparing oranges with oranges, directional equity traders with directional option traders.

Unlike an equity trader who needs to be correct only in the direction, an option trader must be correct in three dimensions: (1) direction, (2) time in which the move will take place, and (3) volatility of the underlying product which is being traded. An equity trader does care about the timing of entry and exit, yet (implied) volatility does not concern the equity trader. Volatility of the overall market does. Just a brief detour without any intent of getting too technical, implied volatility is, according to Investopedia.com, the estimated volatility of a security’s price. My question to the readers is: “Estimated by whom?” The answer is – by the market makers. IV or implied volatility reflects the expectation of the market makers.

Going back to the issue of time, any option trade either bought or sold has a time element built into it. Options have time decay built into their price which equities do not have. The chart below illustrates this point by showing the outcome on four different call scenarios.

Scenario	Option Profits	Stock Price	Time Passage	Volatility change
1	Decreases	Unchanged	Decreases	Unchanged
2	Depends	Increases	Decreases	Decreases
3	Decreases	Decreases	Decreases	Increases
4	Depends	Increases	Decreases	Unchanged

In the first example, the option profits could go down on the directional option trade, if the underlying does not move but goes sideways. The similar situation was with the equity trader who could not be profitable if there was no move in the underlying, yet there was no loss taken for the equity trader. With the directional option trader who is a long a call, with price going sideways, there is already loss in the premium paid due to the time passage. The time left for holding the option decreases regardless of the price move. The time variable always decreases.

Scenario two shows the situation that the stock has gone up in value but the IV has gone down. The fact that the profits box is filled with the word “depends” means that more specifics are need to determine the exact situation of the premium. In the next example, the stock has gone down, the IV has gone up, and there is a loss in the premium. Again, there could be some exceptions to the rules in this kind of environment as well, but generally speaking, the option profits would decrease. The fourth example, shows a situation very similar to the second one, where the stock moves up, while the IV stay unchanged yet there is uncertainty whether the magnitude of the move was great enough to make the call into a profitable play. The overall point of these four scenarios is that option traders must be correct on three things (dimensions). They are: timing, volatility, and also the extent of the move (direction).

Lastly, let us turn our attention to the third reason why I consider options to be three-dimensional. An equity trader has it simple; he or she trades only the stock, whereas an option trader could trade the stock by buying or selling it, as well as trading put and calls on it, or even the combination of all three. Some of the choices are listed below:

Buy the stock and sell a call = covered call.

Buy a call.

Buy a call and simultaneous sell a call = vertical, horizontal, or diagonal spread.

Buy a put.

Buy a put and simultaneous sell a put = vertical, horizontal, or diagonal spread.

Combination of buying calls and selling puts or buying puts and selling calls = synthetics.

The list here is limited because the combinations are truly limitless when the share size of calls and puts changes.

In conclusion, options are 3-D because (a) they trade in all three directions, (b) they also have the component of time and volatility built in them, and lastly, (3) they can involve the trading of the stock, calls, and puts all simultaneously, as well as the combination of them. It is for these reasons that options are call options. The choices are limitless.

Josip Causic, Online Trading Academy Options Instructor

Tuesday, December 9th, 2008 Trading articles

3 Comments to Triple 3-Dimensional Options Are

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