<i>TSC</i> Options Forum: More Jargon-Slashing

Talking lingo connotes a high level of knowledge and expertise, conveys complex concepts and sounds cool.
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Steve, Even though I know the definitions of the "Greeks," I have trouble trying to understand the lingo of postings by experienced option traders and applying them to specific situations. I hope that you might explain some of these concepts:Thanks,---RHR

    What does "gamma-scalping" mean? What does "short a whole lot of vega" mean? Why do "index options have less volatility but more opportunities for gamma-scalping"?

Option traders, like other professionals, love to use industry jargon. Talking the lingo serves several purposes: It connotes a high level of knowledge and expertise in one's specific field, it accurately conveys complex concepts in a concise manner, and it just sounds so cool to say things like, "I'm long vol up the ying-yang and bleeding theta," which basically means one owns options that are suffering from time decay.

The downside of lingo is that sometimes it's used to purposely conceal the true level of understanding, or is simply a means for the speaker to bolster his self-esteem and get the upper hand in a conversation or negotiation. This can be very off-putting to the layperson put in the position of deferring to the expert because he is reluctant to ask a "stupid question." Remember there is no such thing (there are only stupid answers). So, with that in mind, please don't hesitate to keep asking the former, and I'll do my best to supply the latter (though I'll try to keep the stupidity to a minimum).

Swimming in Channeling Stocks

Scalping gamma is a fancy way of saying "I'm trying to buy low and sell high as the price of the underlying stock moves back and forth within a trading range." In last week's

Options Forum we defined gamma as the rate of change in an option's delta (the rate of change in an option's value per a unit change in the price of the underlying security), and showed that its slope decreases as options move into the money and the delta approaches a maximum of 1.

One way to scalp gamma would be to buy straddles (buying both puts and calls) and using the leverage to sell into rallies or buying dips. The keys to trading gamma are maintaining a somewhat delta-neutral position and choosing an issue that trades in a relatively wide but predictable price range. While gamma-scalping is usually based on being long premium, i.e., having a position in which the value of all options purchased is greater than the value of all options sold (otherwise known as a net debit), its success isn't necessarily dependent on a volatility play.

While large price swings, which are helpful for gamma-scalping, can usually prompt implied volatility higher, a change in implied volatility is not really a computational component of the trading strategy. For example, a long, steep decline will usually prompt an increase in implied volatility. But such a move has little benefit for gamma traders maintaining a delta-neutral position.

Tallying Up the Inventory

Vega is the change in an options value for each percentage change in implied volatility. It's expressed in dollar terms, so an option with a vega of 10 would be expected to gain 10 cents (or lose 10 cents), should implied volatility increase from 20% to 20.2% (or decrease to 19.8%).

At-the-money options have a higher vega than out-of-the money options. Longer-dated options have a higher vega than shorter-dated options. For example, if XYZ stock is trading at $50, there are two positions with a negative vega: a net credit vertical spread, such as selling XYZ's January 50 call, and buying XYZ's January 60 call. In addition, you could establish a short calendar spread through buying XYZ's January 50 call and selling XYZ's April 50 call.

Being short vega or having a position with a negative vega is essentially a bet that implied volatility will decline. For professional options traders who carry multiple and overlapping positions, keeping track of overall vega is an important way of measuring their portfolio's exposure to a change in implied volatility.

For example, you could have a delta-neutral position that is constructed of nothing but credit spreads (such as being simultaneously short both put and call spreads with equal but inverse deltas) or short calendar spreads resulting in being "short a whole lot of vega." This means a rise in implied volatility, even if the price of the underlying issue remained unchanged, would create a loss in the overall position. Again, vega is mainly a concern for professionals who carry a large inventory of options positions.

An Index Is an Average

Indices, by their very nature of being an average, usually have a lower volatility than many of their individual components. Consider the volatility of the

S&P 500

index as measured by the VIX, which currently stands at just the 17 level. This is far below the implied volatility of many of its components; even at-the-money options on a staid member such as

General Electric

(GE) - Get Report

are sporting a 25% implied volatility. So the tradeoff is that indices might provide a more predictable range bound by good support and resistance, and the trading range will typically be much narrower than that of a high-volatility stock. While shares of biotechnology or Internet companies can move 5% to 10% a day, the average daily range for the S&P is just 1% over the past six months.

By the way, the reader's email concluded by saying, "I've been doing great with just buying calls in this market environment." In other words, if you have a working knowledge of options and style that is proving profitable, don't worry about understanding every advanced concept.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

Steve Smith.