Tomorrow, Abbott Labs (ABT) goes ex-dividend, paying $0.40; Mid America Apartment Communities (MAA) goes ex- paying $0.615; and Watsco Inc (WSO) goes ex- paying $0.48.

Nothing interesting in ABT or MAA, but WSO puzzled me. The stock was trading at $53.60 and the Oct 55 puts expiring Saturday, were 2.25 bid, 2.75 offered. One way to think about the value of the put is to add up its intrinsic value and the dollar amount of time decay to expiration. In this case, the intrinsic value of the put was 55 – 53.6 = 1.4. Theta is 0.041 per day, so with five days left, that is 0.205 in time decay “value”. Adding it up, we get 1.605 not 2.25.

So one could sell the put and sell stock to hedge. That way, at expiration, the in the money put is exercised and stock is put to me, flattening out my position.

Here is what the return graph looks like (click on the image to enlarge):

So if WSO stays below 55.88, this trade is a winner. Since I am short the stock, I have to pay the dividend which reduces the return. Instead of 2.25 – 1.4 = 0.85, the return is 0.85 – 0.48 = 0.37 minus transaction costs.

Note: This is equivalent to selling the Oct 55 call against cash and letting it expire, if worthless, at the end of the week.

We’ll see if this reasoning holds up.

Some traders use options to speculate on the price movement of an underlying asset; other traders use options to speculate on changes in the volatility, implied or realized, of that asset.  Put a little differently: while no options trader can afford to ignore the role that volatility plays in the price of a contract, not all options traders are interested exclusively or even primarily in volatility. If you’re essentially a stock picker who likes to lever up by buying puts and calls, know that many options traders are doing something different from that.

Recall that there are three components that affect the value of an option: price, time, and implied volatility.* Changes in the price of the underlying asset will affect the price of an option on that asset, as will the passage of time and changes in expectations of future volatility. We measure the exposure an option contract has to those three components and report them as the greek variables delta, theta, and vega. (Vega is not a Greek letter, but it is a greek letter.)

Now, if you’re an options trader of the second type – i.e., not just a stock-picker on steroids – and you have a view to express about volatility, then you’ll want to reduce your exposure to other irrelevant variables. It’s like running a business: if you know you’re good at selling insurance, and if you’ve become one of the biggest and the best insurance companies around, then if you’re smart you’ll think twice before risking your entire company on your ability to make sausages (or to sell OTC credit derivatives, which isn’t so different: you put a lot of nasty stuff in a sack and hope not to hear from your buyers anytime soon).

That’s why options traders and authors in academic finance journals spend so much time thinking about delta hedging. It’s not really an optional line of inquiry, if you’ll pardon the pun: hedging away unwanted risks is a key survival tactic.  Traders who have a consistently profitable thesis about (or skill at trading) volatility will only be profitable overall if they can reduce or eliminate the impact of variables other than volatility. Delta hedging of some form or another is a necessary but not sufficient condition for successful options trading.

In the followup to this post, we’ll look at some popular methods for hedging away delta risk.

* Of course, interest rates and other carrying costs matter, too, but not nearly as much, and not enough to warrant discussion in this post.

Don’t Over Fit

Part of his comfort with the methodology, I believe,  comes from his testing. He has tested his trade back over many years and sees how it performs.  There is a danger to creating trading strategies by backtesting.   There is a need to” improve” the parameters of the trading method so that the trading results improve.  This is a trap.  If the method works, it should work over a range of parameters.  If the parameters need to be fine tuned, that is a sign that they have been over-fitted.  They may have worked in the past, but probably will not work in the future.

One way to be sure to avoid this bias is to create your trading method over  say the past five years, but take out six months of three of the years.   Then once you have a method that you like, test it on the three six month periods that you did not look at.  That way if you have over fitted the parameters, the trades in the test periods won’t do well.

Juan has kept his trade parameters very simple and consistent.  That is a good sign.

How Does The Trade Behave?

He also has a very clear idea of why his trade does what it does. In other words, what are the hidden factors in the trade. Does it have an underlying bullish bias? Does it need volatility to increase to be profitable? What does time decay do to the trade? Does it profit from sharp moves or suffer?

Another piece of the puzzle is the time frame of the trade.  Are you most comfortable closing out all your trades every day?  Or every Friday?  Or do you want your trades to work over a month or two?  How are you most comfortable?

These are all important elements in creating a successful trader.