Options are Two-Dimensional

Options are Two-Dimensional

What happened? How did these VIP call options lose money even though the stock’s price went up? The reason the VIP options lost money is because op­tions have two main factors that affect their price: direction and speed. Because of this, we say that options are two-dimensional. In order to be profitable, you must correctly guess the direction of the underlying stock along with the speed at which the stock’s price will move. Option traders must correctly guess the direction (up or down) of the underlying stock as well as how quickly it will move (will it move today or next week?). Stock traders, on the other hand, only trade in one dimension. They only need to correctly guess whether the stock’s price will rise or fall. They do not need to account for the speed.

It is the volatility of the underlying stock that determines the speed com­ponent. If you are trading options on a highly volatile stock then that stock’s price must move quickly in order for that option to become profitable. The reason has to do with the fact that there is a direct relationship between volatil­ity and option prices. If volatility rises, so do call and put prices. But if volatility falls, then call and put prices fall in response. Volatility, however, is a hidden component to option prices. It is easy to see if the stock’s price goes up or down but it is not so easy to get the same information about volatility. It is certainly possible for the stock’s price to rise but for volatility to fall enough so that there is an overall decrease in the call option’s value. This is exactly what happened with the VIP calls in Figures 1 and 2. In this example, the option trader got the stock direction right but not the speed; it took too long for the stock to rise. If the stock had moved to $34 in a shorter time, say a day or two (rather than thirteen), the calls would certainly have made money. It is this second dimen­sion of speed that makes options trading so much more difficult than stock trading. Notice that a one-dimensional stock trader would have made money by purchasing at $31.41 and selling for $34. The speed at which the stock rises does not matter. Therefore, while a stock and option trader may both have guessed that VIP was moving higher, only the stock trader made money since he does not need to account for speed at which the stock gets to a certain price.

This example shows that call options are not necessarily a direct substitute for stock. If you think a stock is moving higher, you cannot just buy a call in place of the stock and expect to make money if you are correct. (Similarly, put options are not a direct substitute for shorting stock.) Yet most option traders mistakenly apply this one-dimensional stock trading technique to options and, consequently, end up losing money.

Understanding candlestick charts will take care of the directional aspect. Understanding volatility will take care of the speed aspect. Only when we have correctly identified both direction and speed can we expect to make money with options.

You must be convinced that the speed of movement in the stock’s price matters. So before we get into the details of how to identify both direction and speed, let’s look at a quick analogy to convince you that speed matters.