Direction Neutral, Direction Biased, and Direction Indifferent

As typically traded, volatility-selling option strategies are direction neutral.This means that the position has the greatest results if the underlying price remains in a range—that is, neutral. Although some option-selling strategies—for example, a naked put—may have a positive or negative delta in the short term, profit potential is decidedly limited.Option-buying strategies can be either direction biased or direction indifferent.

Direction-biased strategies have been shown throughout this chapter. They are delta trades. Direction-indifferent strategies are those that benefit from increased volatility in the underlying but where the direction of the move is irrelevant to the profitability of the trade. Movement in eitherdirection creates a winner.Are You a Buyer or a Seller? The question is: which is better, selling volatility or buying volatility?

I have attended option seminars with instructors (many of whom I regard with great respect) teaching that volatility-selling strategies, or income-generating strategies, are superior to buying options. I also know option gurus that tout the superiority of buying options. The answer to the question of which is better is simple: it’s all a matter of personal preference.When I began trading on the floor of Chicago Board Options Exchange (CBOE) in the 1990s, I quickly became aware of a dichotomy among my market-making peers.

Those making markets on the floor of the exchange at that time were divided into two groups: teenie buyers and teenie sellers.Teenie Buyers:Before options traded in decimals (dollars and cents) like they do today,the lowest price increment in which an option could be traded was one sixteenth of a dollar—a teenie. Teenie buyers were market makers who would buy back OTM options at one sixteenth to eliminate short positions.

They would sometimes even initiate long OTM option positions at a teenie, too. The focus of the teenie-buyer school of thought was the fact that long options have unlimited reward, while short options have unlimited risk. An option purchased so far OTM that it was offered at one sixteenth is unlikely to end up profitable, but it’s an inexpensive lottery ticket. At worst, the trader can only lose a teenie.

Teenie buyers felt being short OTM options that could be closed by paying a sixteenth was an unreasonable risk.Teenie Sellers:Teenie sellers, however, focused on the fact that options offered at one sixteenth were far enough OTM that they were very likely to expire worthless. This appears to be free money, unless the unexpected occurs, in which case potential losses can be unlimited.

Teenie sellers would routinely save themselves $6.25 (one sixteenth of a dollar per contract representing 100 shares) by selling their long OTMs at a teenie to close the position. They sometimes would even initiate short OTM contracts at one sixteenth.These long-option or short-option biases hold for other types of strategies as well. Volatility-selling positions, such as the iron condor, can be constructed to have limited risk.

The paradigm for these strategies is they tend to produce winners more often than not. But when the position loses,the trader loses more than he would stand to profit if the trade worked out favorably.Herein lies the issue of preference. Long-option traders would rather trade Babe Ruthstyle. For years, Babe Ruth was the record holder for the most home runs. At the same time, he was also the record holder for the most strikeouts.

The born fighters that are option buyers accept the fact that they will have more strikeouts, possibly many more strikeouts, than winning trades. But the strategy dictates that the profit on one winner more than makes up for the string of small losers.Short-option traders, conversely, like to have everything cool and copacetic. They like the warm and fuzzy feeling they get from the fact that month after month they tend to generate winners. The occasional loser that nullifies a few months of profits is all part of the game.