Introduction to Trading Styles
One of the most successful investment professionals in the world today spoke these wise words: “Some people with high IQs are terrible investors because they’ve got terrible temperaments. That is why we say that having a certain kind of temperament is more important than brains.”
Think about that. According to Charlie Munger, Warren Buffet’s most trusted advisor, trading in a way that matches your temperament may be more important than how much you know about the markets. Options are extremely versatile instruments and can be used in many different ways. Experienced option traders tend to select and refine a trading style that is most effective for their temperament.
One simple way to understand the most commonly used option trading styles is to learn a little bit about something called option Greeks. These are the power tools of the option trading world. They are measures that help traders better anticipate the way option prices might move. There are many of these measures, but the three most commonly used ones are Gamma, Theta and Delta. Here is a simple definition for each.
Delta measures how sensitive an option is to its underlying stock’s price movement. So a high delta score means the option and the stock move similarly. A low delta score means the stock has to move more dramatically to change the option price.
Theta measures the amount of time decay an option will experience. Theta scores are negative numbers and they become more negative for an option as the expiration date approaches.
Gamma measures the potential for price acceleration of the option. The higher the gamma score the more the Delta score of an option will change as the stock price moves.
To help new traders get properly introduced to the key aspects of option trading, Options Academy has sorted option trading into three distinct styles based on each of these three measures. These three measures align well with the three factors discussed in part two of this Beginner’s Guide. Factor number one, Market Action, aligns closely with Gamma, while factor number two, time decay, aligns with Theta, and factor number three, the underlying stock movement, aligns with Delta. If you take a closer look at each of these trading styles you may begin to understand why it is important to learn more about them.
|Factors moving price||Focus of the trading style||Primary Approach|
|Gamma||Market Action||Capturing price acceleration||Buying|
|Theta||Time Decay||Collecting time value||Selling|
|Delta||Stock Price movement||Leveraging stock price moves||Either|
Trading Style # 1: Gamma
Gamma measures the potential for option price increases to accelerate. The gamma style of trading seeks to buy options that could become more valuable at increasing rates. Gamma style trading seeks to capture unexpected and significant moves. This works well for those who want to approach the market as option buyers. This trading style can be done in short, intermediate, or even longer trading time frames, but usually works best in short-term or intermediate trading.
Trading Style # 2: Theta
Theta measures the amount of time decay an option should expect for one day. The rate of decay is not linear. It starts off slowly and accelerates as the expiration date approaches. Theta style trading usually works well for those who want to approach the market as sellers. Since time decay works against the option buyer, but works in favor of the option seller, the strategies that best work with this style typically focus on collecting time value rather than paying it.
Trading Style # 3: Delta
Delta style trading balances risk and reward to have a better than even chance of winning. This style of trading helps traders seek the most effective ways to leverage stock moves. That’s because Delta measures the sensitivity of an option’s price to movement in the underlying stock. The strategies that work with this trading style effectively trades the swings of stock prices. Traders who specialize in Delta-style option trading may approach the market as either a buyer or a seller. Whichever they choose, they will often rely on shorter timeframes for their intended outcomes.
Option traders who select one of the three trading styles and study its strategies in depth may find that they can learn about option strategies faster and more effectively. The next part of the Beginner’s Guide will discuss which option strategies are aligned with each of these three option styles.