Options: Not a Zero-Sum Game
With the possible exception of futures contracts, trading is not a zero-sum game. In other words, for every winner there doesn't have to be a loser. Therefore, because there are so many different combinations and ways options can be hedged against each other, it doesn't make sense to look at overall figures (e.g., the number of options that expire worthless) and reach conclusions about how many people made or lost money.
For simplicity, let's take the case of a spread. The fact that one person made money buying a butterfly does not automatically mean that someone else lost. Instead, the person who sold the butterfly may have traded out of the position using spreads or by selling individual options. For every person who is long a butterfly, call spread, put spread, or whatever, there are not necessarily people who are short the corresponding position. As such, the profitability of their positions will necessarily differ.
Know your competition
In many respects, option trading is a game of strategy not unlike competitive sports or chess tournaments. The main difference is that in trading there are more players and multiple agendas.
To succeed, it's important to have a knowledge and appreciation of the other players. In general terms, you must gain an appreciation for the behavior and motivations of the different players.
In the option markets, the players fall into four categories:
• The Exchanges
• Financial Institution
• Market Makers
• Individual (Retail) Investors
What follows is a brief overview of each group along with insights into their trading objectives and strategies.
The Exchanges
The exchange is a pblace where market makers and traders gather to buy and sell stocks, options, bonds, futures, and other financial instruments. Since 1973 when the Chicago Board Options Exchange first began trading options, a number of other players have emerged. At first, the exchanges each maintained separate listings and therefore didn't trade the same contracts. In recent years this has changed.
Now that BSE and NSE both these exchanges list and trade the same contracts, they compete with each other. Nevertheless, even though a stock may be listed on multiple exchanges, one
exchange generally handles the bulk of the volume. This would be considered the dominant exchange for that particular option.
The competition between exchanges has been particularly valuable to professional traders who have created complex computer programs to monitor price discrepancies between exchanges.
These discrepancies, though small, can be extraordinarily profitable for traders with the ability and speed to take advantage. More often than not, professional traders simply use multiple exchanges to get the best prices on their trades.
Deciding between the two would be simply a matter of choosing the exchange that does the most trading in this contract. The more volume the exchange does, the more liquid the contract.
Greater liquidity increases the likelihood the trade will get filled at the best price.
Financial Institutions
Financial institutions are pbrofessional investment management companies that typically fall into several main categories: mutual funds, hedge funds, insurance companies, stock funds. In each case, these money managers control large portfolios of stocks, options, and other financial instruments. Although individual strategies differ, institutions share the same goal-to outperform the market. In a very real sense, their livelihood depends on performance because the investors who make up any fund tend to be a fickle group. When fund don't perform, investors are often quick to move money in search of higher returns.
Where individual investors might be more likely to trade equity options related to specific stocks, fund managers often use index options to better approximate their overall portfolios. For example, a fund that invests heavily in a broad range of tech stocks will use NSE Nifty Index options rather than separate options for each stock in their portfolio. Theoretically, the performance of this index would be relatively close to the performance of a subset of comparable high tech stocks the fund manager might have in his or her portfolio.
Market Makers
Market makers are the traders on the floor of the exchanges who create liquidity by providing two-sided markets. In each counter, the competition between market makers keeps the spread between the bid and the offer relatively narrow. Nevertheless, it's the spread that partially compensates market makers for the risk of willingly taking either side of a trade.
For market makers, the ideal situation would be to "scalp" every trade. More often than not, however, market makers don't benefit from an endless flow of perfectly offsetting trades to scalp.
As a result, they have to find other ways to profit. In general, there are four trading techniques that characterize how different market makers trade options. Any or all of these techniques may be employed by the same market maker depending on trading conditions.
• Day Traders
• Premium Sellers
• Spread Traders
• Theoretical Traders Day traders
Day traders, on or off the trading screen, tend to use small positions to capitalize on intra-day market movement. Since their objective is not to hold a position for extended periods, day traders generally don't hedge options with the underlying stock. At the same time, they tend to be less concerned about delta, gamma, and other highly analytical aspects of option pricing.
Premium Sellers
Just like the name implies, premium sellers tend to focus their efforts selling high priced options and taking advantage of the time decay factor by buying them later at a lower price. This strategy works well in the absence of large, unexpected price swings but can be extremely risky when volatility skyrockets.
Spread Traders
Like other market makers, spread traders often end up with large positions but they get there by focusing on spreads. In this way, even the largest of positions will be somewhat naturally hedged. Spread traders employ a variety of strategies buying certain options and selling others to offset the risk. Some of these strategies like reversals, conversions, and boxes are primarily used by floor traders because they take advantage of minor price discrepancies that often only exist for seconds. However, spread traders will use strategies like butterflies, condors, call spreads, and put spreads that can be used quite effectively by individual investors.
Theoretical Traders
By readily making two-sided markets, market makers often find themselves with substantial option positions across a variety of months and strike prices. The same thing happens to theoretical traders who use complex mathematical models to sell options that are overpriced and buy options that are relatively underpriced. Of the four groups, theoretical traders are often the most analytical in that they are constantly evaluating their position to determine the effects of changes in price, volatility, and time.
Individual (Retail)
As option volume increases, the role of individual investors becomes more important because they account for over 90% of the volume. That's especially impressive when you consider that option volume in February 2000 was 56.2 million contracts-an astounding 85% increase over February 1999
The Psychology of the Individual Investor
From a psychological standpoint, individual investors are in interesting group because there are probably as many strategies and objectives as there are individuals. For some, options are a
means to generate additional income through relatively conservative strategies such as covered calls. For others, options in the form of protective puts provide an excellent form of insurance to lock in profits or prevent losses from new positions. More risk tolerant individuals use options for the leverage they provide. These people are willing to trade options for large percentage gains even knowing their entire investment may be on the line.
In a sense, taking a position in the market automatically means that you are competing with countless investors from the categories described above. While that may be true, avoid making direct comparisons when it comes to your trading results. The only person you should compete with is yourself. As long as you are learning, improving, and having fun, it doesn't matter how the rest of the world is doing.