A stock option trading system makes bets on whether volatility will increase or decrease. To the casual observer, options look like they are bets on whether the stock will rise or fall, but they are actually bets on whether the price will rise or fall faster than expected. In other words, buyers of calls are betting stock prices will increase faster than built into the premium, while buyers of puts are betting prices will fall faster than was anticipated when the premium was set.
All of the slight variations on a stock option trading system produce a plethora of complex positions with names such as butterflies, iron condors, and reverse butterflies. These complex positions are usually an effort to make a pure volatility bet with indifference as to direction. All of these strategies can be successful if one doesn’t have to pay commissions. It is quite easy for a complex position to generate such large commission costs that even if the underlying stock behaves as expected, the trader loses money. If the underlying stock doesn’t behave as expected, the trader loses even more money.
One of the buzz phrases of options trading is “delta neutral.” In options, that is essentially the same thing as betting that volatility will decrease. According to theory, if a stock option trading system constantly rebalances its portfolios to remain delta neutral, over time the premiums will accrue to the account the system is trading, without regard to which way the stocks that underlie the options move. There are two major problems with a delta neutral approach: commissions and the somewhat cyclic nature of volatility. Betting that volatility will decrease can be both very difficult and costly to sustain when volatility is increasing.
A final approach that a stock option trading system can use is to look for deep out of the money positions that are mispriced. Theoretically, incorrect pricing of deep out of the money options is common for reasons that have to do with the math of options pricing. The theory is that one will buy these cheap options, inevitably getting paid in the long run when volatility increases enough to make them valuable. Capitalizing on options mispricing requires an immense amount of money and a very long time frame. One can buy every severely mispriced option on the market and make no profits for years, as at least one large fund has done.
