2 Different Types of Options Traders
This is a very important options lesson prevents confusion and saves you invaluable time. You'll learn that there are 2 different types of options traders that profit in very distinct ways:
- Volatility Traders
- Directional Leverage Traders
In this lesson, you'll learn what these 2 different types of traders focus on, how they profit, and where the confusion comes from.
How to Profit
Volatility Traders are skilled professionals that profit with options by using mathematical formulas. The most famous formula is called the "Black-Scholes formula" and its derivatives, "The Greeks.”
In a nutshell, Volatility Traders focus on how a stock (or asset) gets to its future price, as opposed to if it gets there at all.
In fact, Volatility Traders try to remove all directional price risk associated with the underlying stock. They use a strategy that does not rely on correctly predicting the stock's direction. Instead, profits are dependent on how much the stock moves over a set time period (i.e. daily).
More specifically, the Volatility Trader extracts profits by systematically trading the moves in the underlying stock. Keep in mind, the mathematical opportunities for the Volatility Trader comes in very small increments. Thus, they need to make enough trades to capture "pennies."
Who Trades Volatility?
Volatility Trading requires substantial capital, expensive software, continuous trading, and low-cost transaction fees in order to be profitable. For this reason, Volatility Trading is done by the Investment Banks and a few Hedge Funds.
Citadel is one of the most famous Hedge Funds that trades volatility.
Several Volatility products (i.e. VIX, VXX) gained popularity over the last decade. These volatility products trade similar to stock. You profit with them by correctly predicting the direction of “Volatility.”
It's important to make the distinction that this is not “Volatility Trading” as described above. There is a significant difference.
That said, it’s highly likely that you are not a Volatility Trader. You're most likely a “Directional Leverage” Trader.
Directional Leverage Traders
How to Profit
“Directional Leverage” Traders profit from the direction of the underlying asset. Options are the tool that offers them leverage.
This is the simplest form of options trading and it's how the Top investors in the world trade options.
Unfortunately, investors get confused because the industry's education conflates the issues facing the Volatility Trader and the Directional Leverage Trader.
Remember, the Volatility Trader cares about how the stock gets to a future price and then extracts profits by using the Black-Scholes formula.
The Directional Leverage Trader cares if the asset gets to a specific future price (a Target Stock Price) by the option's expiration date.
The Risks They Face
The primary risks for the Directional Leverage trader are the:
- Current option price.
- Potential future option price.
- Direction of the underlying asset within a certain period of time.
Assessing these risks correctly significantly diminishes any volatility risk associated with the option.
Different Use Cases
Directional Leverage takes on different forms.
For example, investors can hedge (insure) a portfolio or stock with options. The options give them leverage should there be an adverse move in the stock.
Investors can also buy options to leverage a specific direction in the stock.
And some investors that are unsure of the direction might use options to manage the risk-reward profile of their portfolio.
Volatility & Selling Options
Many retail investors that sell options because they believe that they inherit a "volatility advantage," or an edge. In fact, they ultimately learn that the directional risk of the stock far outweighs any volatility advantage they assume to have found.
For example, it is very possible to profit from the volatility risk of an option, yet experience significant losses on the position. Remember, in order to make a pure Volatility Trade, the investor must neutralize all directional risk at all times.
These nuances are rarely explained in the available Options Education, likely because it reveals how hard it is to be a successful Volatility Trader.
In the next lesson, I'll put into context how many volatility traders there are vs. directional leverage traders. I think you'll be surprised.