The First Options Lesson No One Gets

If you have spent any time learning options, you probably know the pattern.

You start with a simple question:

Which option should I buy?

Then come Delta, implied volatility, ITM versus ATM versus OTM, Theta, probability, historical volatility and risk tolerance. Each concept may be useful, but after learning them, many investors still cannot answer the question that brought them there.

Before learning another Greek or volatility measure, there is something more fundamental to understand.

It is a distinction that should be the first lesson in options education, yet most investors never receive it.

There are two fundamentally different ways to approach options: volatility trading and directional investing.

Two Ways to Use Options

A professional volatility trader is generally trying to avoid making money from the direction of the stock.

The trader may buy and sell options, buy and sell stock against those options, and adjust positions to reduce or remove directional exposure. The goal is not simply to predict whether a stock will rise or fall. What matters is how the stock moves, how much it moves, how volatility changes, what was priced into the options and how those exposures are managed.

A directional investor is doing something very different.

The directional investor begins with a view about the underlying investment:

The option is a vehicle for expressing that view.

What Volatility Trading Really Means

The terminology can be confusing because many directional investors use volatility information when making trades.

You may look at implied volatility before buying a call, or check IV rank before selling a covered call. You may decide that an option looks expensive because volatility is elevated.

That does not make you a volatility trader.

You are still making a directional investment decision and using volatility as one input.

Professional volatility trading means something much more specific. The trader is trying to make money from volatility itself while reducing or hedging the directional exposure to the underlying stock. That usually means managing Delta across a portfolio of options and continuously adjusting the position as the stock moves.

The same distinction applies to the VIX. If you believe the VIX is going from 15 to 25 and buy VIX calls, you are trading an instrument tied to volatility, but the trade itself is directional. You need the VIX to move in the direction you predicted.

A professional volatility trader may instead be comparing implied volatility with realized volatility, trading skew or term structure, managing Gamma and Vega, and hedging Delta across a book of options.

In simple terms:

Using volatility to help make a directional decision is not volatility trading.

A volatility trader is primarily trading how something moves. A directional investor is primarily trading where something goes.

Different Traders, Different Processes

The difference becomes clearer when you look at what professional volatility traders actually manage.

A directional investor may have a handful of investment ideas. A professional market maker or derivatives trader can be managing hundreds or thousands of option positions and exposures across different stocks, strikes and expirations.

There is no practical way to manage a book like that by having an individual stock opinion on every position. The trader needs a common language that turns those positions into measurable risks. That is why Delta, Gamma, Vega, Theta, implied volatility and theoretical value are so important in professional volatility trading.

That is a very different process from an investor asking:

“I think this $100 stock can reach $130. Which call should I buy?”

Who Trades Volatility and Who Trades Direction?

Volatility traders generally work in three places:

What makes someone a volatility trader is not where they work.

It’s how they use options to make money.

This is where the term “hedge fund” can cause confusion. People sometimes hear hedge fund and assume the options trader must be trading volatility or thinking like a market maker. That is generally not the case.

Most hedge fund portfolio managers are directional investors. They develop views on companies, events or markets and may use options for leverage, protection or a particular payoff.

Large multi-strategy hedge funds can have both types under the same roof. One portfolio manager may believe a stock is dramatically undervalued and use calls for leverage. Another trader at the same firm may run a volatility book designed to make money from volatility itself.

Both trade options.

They are not doing the same thing.

How the Options Market Changed

The options market has changed enormously over the past five decades.

In the 1970s, listed options were primarily the domain of professional floor traders and market makers.

During the 1980s and 1990s, investment banks built large derivatives businesses and developed a growing customer base of hedge funds, asset managers, insurance companies and other institutional investors. These customers often had investment views and wanted leverage, protection or customized exposure.

Then, in the 2000s, online brokerage opened the options market to a much larger group of individual investors. At the same time, market making increasingly moved away from trading floors and toward electronic firms capable of pricing and trading enormous numbers of options.

The important change was not simply how options were traded.

More and more directional investors became options customers.

And this was not merely a retail problem that appeared when online options trading became popular.

When I started speaking with institutional investors in 1995, including some of the largest hedge funds, their most common question was the same one individual investors still ask today:

Which option should I choose?

These were sophisticated investors. They understood companies, catalysts, valuation and risk. They were using options for leverage, hedging and asymmetric exposure.

But they were not volatility traders. They were directional investors trying to figure out how to translate an investment view into the right option.

Retail investors later arrived with the same problem on a much larger scale.

The question never changed.

The Education Did Not Change With the Customer

Options education started in the 1970s with professional volatility trading firms such as O'Connor & Associates. These firms had to train traders to price options, hedge risk and manage large derivatives books, so they developed rigorous training around theoretical value, volatility and the Greeks.

As traders from firms like O'Connor moved into senior roles at investment banks, that training moved with them. Banks then taught generations of derivatives traders, salespeople, structurers and risk managers using the same professional framework: Delta, Gamma, Vega, Theta, implied volatility, realized volatility, theoretical value, skew and hedging.

And that framework didn't stay inside trading firms and investment banks. It also became the foundation of many of the books investors used to learn options.

McMillan is a good example of how professional derivatives thinking became part of mainstream options education. His background was in professional trading, and his own biography says his work focused heavily on “options, volatility and derivatives trading.”

The point is not that this education was wrong. It was built for a different problem.

The industry eventually formalized options education for a broader audience through the Options Industry Council, formed in 1992 to educate investors about listed options. Its instructors have continued to come heavily from the professional options world, including former market makers, floor traders and derivatives professionals.

Then options education moved online.

Thinkorswim became an important part of that transition. Its co-founder Tom Sosnoff spent roughly two decades as a market maker on the Chicago Board Options Exchange before helping build thinkorswim around sophisticated options trading tools and education.

This put technology that had once belonged largely to professional options traders directly in front of individual investors. Option chains, Greeks, theoretical values, volatility analytics and advanced trading tools became available on an ordinary investor's computer.

The technology was new.

The customer was new.

The educational framework was not.

To this day, most industry options educators are former market makers. They may understand option pricing better than almost anyone listening to them. But the issue is not whether they understand options…

The question is whether an educational framework that grew out of professional volatility trading meets the needs of a directional investor.

The Mismatch

Put those two timelines next to each other and the mismatch becomes clear.

The market changed. The customer changed.

The education did not change with them.

This creates a fundamental problem for a directional investor. Someone who starts with a relatively simple investment idea is quickly pulled into an analytical framework designed to price options, hedge risk and manage large volatility books.

For example, when choosing an option, traditional education usually points to questions like these:

If Delta, Gamma, Theta, Vega, implied volatility, historical volatility, probability, moneyness and risk tolerance are all supposed to tell a directional investor which option to buy, there should be a process connecting them to a specific answer.

There isn't.

A clear, defensible process cannot be found in traditional options education.

The more useful questions for a directional investor begin somewhere else:

Notice the shift? The questions are now about the stock first.

A Different Perspective

For a directional investor, this is the hardest options question:

Which option should I choose?

Top hedge fund managers know how to answer it because they approach options from the directional investor’s perspective.

I have taken more than 20 years of Wall Street experience working with these investors and turned that approach into a simple process you can follow.

No Greeks. No implied volatility. No Black-Scholes.

Are you ready to take the next step?

Next: How to Choose the Right Option Strike: The Step Most Guides Skip →