Is it important to understand option pricing models before trading options?

Question

Options seem to be one of the most complex financial instruments generally available to retail investors. The common advice given to beginners (at least on this site) is that beginners "must really know what they are doing" before trading options. Since I am a beginner and I intend to trade options some day, I started reading books about options so that I can "really know what I'm doing". However, I feel like I've fallen down the rabbit hole because I haven't even bought or sold my first option despite having read a lot about options. I'm wondering: at what point can I consider myself knowledgeable enough to trade options?

Do I need to understand the "Greeks" in detail (e.g. its meanings and mathematical derivations)? Do I need to learn and understand options pricing models such as the binomial option pricing model, the Black-Scholes model, the Bjerksund-Stensland model, etc. before trading options? What about things like "dynamic hedging"?

When does a beginner "know enough" to begin trading options?

Answer 1

I've utilized options on the retail level for well close to 40 years, starting with basic strategies and evolving into more complex strategies, particularly hedging. I wrote utilized because I have never been that typical perception of the 'trader' who has loaded up on cheap puts or calls, gunning for that big pay day.

Yes, options are complex financial instruments and it is essential to know what you are doing before trading them. Warren Buffett once called derivatives “financial weapons of mass destruction” yet he has made billions of dollars from using them.

The amount of knowledge that you need depends on the complexity of what you are doing. You don't need to know very much if you are a Level 1 option trader selling covered calls in order to sell your stock at a target price or selling cash secured puts to acquire stock at a lower price. These strategies are quite straightforward.

The next levels of option strategies (straddles, strangles, spreads, condors, butterflies, hedging) require more knowledge because for lack of a better description, they're more like chess than checkers.

Trading volatility as well as active hedging gets even deeper and is about the most complex that I have gone into.

Here are some generalizations applicable to these more sophisticated strategies. You need to understand:

• The interconnected relationship of options and different strategies

• How to use an option pricing formula (not the actual mathematics of one or more formulas)

• How options behave in relation to dividends, change in time, price, implied volatility

• How to evaluate the P&L of various positions at and before expiration

• Synthetics

• How to adjust positions efficiently and when to adjust them

• Practical usage more than classroom theory

• And possibly most important of all, you need to know what you want to achieve with options and what's within your ability. "A man has to know his limitations" - Harry Callahan.

I've never had any use for the Greeks other than delta since I hedge a lot, often having 1/2 a dozen or so different options of the same underlying. I need to know my directional exposure. I'm somewhere in the middle, well beyond Level 1 trading but far short of the pro managing a large option portfolio.

My go to recommendation for those aspiring to learn about options is "Options as a Strategic Investment" by Lawrence G. McMillan. Read it. Then read it again.

When does a beginner "know enough" to begin trading options?

I'd compare this process to learning a foreign language. You can memorize all the words that you want but until you can think the language, you're just a translator, not a speaker. You need to speak the language before you're ready to do more than basic strategies.

Answer 2

When does a beginner "know enough" to begin trading options?

I think it's important to note that if you have a

• basic everyday understanding of stocks and if you

• (basically) know what a call is and how it works (you simply understand what strike price and expiry is) and you find the basic concept obvious and simple,

it's completely, totally normal to "trade options" (in a basic manner) with that knowledge.

Say you're musical. If so, any fool can strum three cords on a guitar and sing a folk song. The answer is exactly that you do not need to know vast musical theory to play great folks songs.

But you won't be able to do the sort of things Mr.B describes in the other answer unless you're Eddie van Halen.

So, for me for example I rarely traded stocks. But say I thought "Apple was going up", I'd just buy a couple appropriate calls, rather than waste a whole lot of money on buying a pile of Apple stock.

So, that's easy as (Apple?) pie. You can do that.

But I know nothing (and care less) about all the complex stuff mentioned. (Thank God, I ask or read on this web site when I want such knowledge, to satisfy curiosity.) So, in answer to your question I am the perfect example of someone who can NOT do "strategy options"; as I know Nothing.

{My guess is the only way you could get to that is with step by step experiential learning.}

So sure. It's totally, completely, commonplace that folks "buy calls" (or perhaps write calls if they are, you know, startup stockowner types) with only basic knowledge of options.

That's fine and dandy and you are good to go.

But you'll be throwing money away if you try "strategic" options until you have vast technical knowledge.

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^** Err, do note that in "sing folks songs with guitar" analogy, if you can't sing, unfortunately you're screwed. It doesn't matter how much you practice guitar and learn music theory :/