Traders Edge Blog

Coaches Corner:
The Greeks

In this month’s coaches corner I’d like to initiate a basic discussion of what’s known in the world of options as the Option Greeks.

When you’re a new option trader, learning the Greeks is like learning to drive; you need only know where to turn the key and not necessarily how everything works under the hood. I would argue that the mathematical formulas and concepts behind the Greek formulas are far more complicated than learning the mechanics of how a car’s engine works. As such, we’ll keep the discussion simple today, with the opportunity of exploring each Option Greek in more detail at a later date.

The Option Greeks are a series of useful variables that explain the various factors driving movement in option premiums. Mathematically speaking, the Greeks are all derived from an options pricing model; the most well known being the Black-Scholes formula produced in 1973. The four most important Greeks to know are: delta, gamma, theta and vega. They are important to know because each isolates a variable that can drive options price movement despite the movement of the underlying asset at a given time.

Now as Preston often points out, not all Greeks are created equal, so we need to pay more attention to some than others. For example, you’ll notice that a trader like Jeff Augen is so acutely aware of vega that he will build trades purely on the premise of gaining or hedging, focused on this one key variable. Controlling or manipulating all you can in your trades is an important part of high probability trading. Many of the trading techniques you will learn in your career will require simple knowledge of which Greeks affect which technique and how.

Delta

Let’s start with the Option Greek called delta because this is the one Preston mentions the most in his 1% Solution. Delta is the Greek that dictates an option’s theoretical price correlative to the underlying’s movement for every one dollar, assuming everything else stays constant. For example, if you buy a call option worth $5.00 with a delta of 0.50, then for every one dollar move up or down in the underlying asset your option will gain or lose 0.50 cents. The further you go ITM on the option’s chain the closer the delta goes to 1, while the further you go OTM on the option’s chain the closer the delta goes to zero.

The delta also represents the percentage chance the option will end INT; thus a 0.50 delta would forecast a 50 percent chance your trade will end ITM and deliver profits. The 0.50 delta typically resides at ATM strikes. Note that the further ITM you go the less the deltas change per strike, but the more price increases per strike. You want to avoid the trap of thinking that just because an option has a delta closest to 1 that it has the most bang for the buck. Imagine you have a stock worth $100 and two strikes to choose from for a directional call trade: one strike worth $5 that has a delta of 0.75 and one strike worth $15 with a delta of 1. Which one would you chose? Your best bet is to risk $5 to make 0.75 cents per dollar move because it has an initial yield of 0.75/5, equaling 15 percent, which is far greater than the yield of 1/15, equaling 6.66 percent.

Inversely, you shouldn’t automatically assume that OTM positions are the best because they cost relatively less—they also offer less probability. A strike worth 0.10 cents with a delta of 0.05 might have an initial yield of 0.05/0.10, equaling 50 percent, but the chance the stock will end above a strike that is so far out of the money is not good. Many traders claim the ideal option strike to purchase is the one that correlates with a 0.70 delta because it has great yield and a high probability for success.

Gamma

Keep in mind that delta is dynamic, which leads us to our next Option Greek, known as gamma. Using the earlier example where we bought an option worth $5 with a delta of 0.50, let’s say the stock sat initially at $100, butmoved to $101. Would the call option move another 0.50 cents? Would it move more or less if the stock moved from $101 to $102? The answer is it would move more
than 0.50 cents since movement from $101 to $102 would mean the call option is becoming more ITM—the delta will increase to reflect the price movement. This change in delta is known as gamma, or the rate of change of delta.

Two things to know about gamma: First, the closer the expiration of the option the quicker the gamma moves, and second, gamma’s impact is highest for ATM strikes—the impact lessens the further ITM and OTM the strikes are. This variable of gamma can affect calendar spreads, especially when buying long-term options in place of stock and selling short-term options against those purchased options. For example, if a stock has a delta of 1, the short-term sold options can never cost you more than the stock’s appreciation. Hence, covered
calls have a maximum profit above the sold call strike and no loss potential. When buying calls instead of stock, you’ll find the bought option can have a delta less than 1, which means there’s a chance the sold option could cause more losses than the bought options might gain based on the shorter-term sold options’ quicker gamma.

Theta

The next Option Greek, theta (aka time decay), is one you’ve probably heard Preston utilize to take advantage of time decay in many of his option techniques. Theta can be best described as the variable which tells you how much an option’s price will diminish over time, which is the rate of time decay of option premium. Time decay is the phenomenon in which the value of options reduce over time even though the underlying stock remains flat. Time decay occurs because the extrinsic value, which is also known as the Time Value, of options invariably diminish as expiration draws nearer.

The Money Press trade we often utilize is an excellent candidate for taking advantage of theta—the sold leg of the spread represents the money-making piece of the technique from one week to the next. Conversely, when utilizing directional options trading strategies, such as a bought put, the time decay is the enemy and offsetting it is important.

The most important note about theta is that the closer to expiration the option gets the quicker the theta decays. Because of this, a trader might consider buying more time than needed in a directional trade to hedge against this risk.

Vega

Probably the most important Option Greek to specialized option traders is vega, which is the variable that tells us approximately how much option premium will increase or decrease given an increase or decrease in the level of implied volatility. An easy definition of implied volatility is the relative rate at which the price of an asset moves up and down. It can be determined by calculating the annualized standard deviation of daily change in price. If the price of a stock moves up and down rapidly over short time periods, it has high volatility; if the price almost never changes, it has low volatility.

Three important things to know about Vega: First, vega can increase or decrease regardless of whether the underlying price changes—this is due to expected events in the future (e.g. earnings, drug approvals, law suits, etc.) that can potentially cause big movement in the underlying. Second, vega typically increases when the market or underlying falls and it decreases when the
market or underlying rises, but it should be noted that the inverse relationship sometimes fails to hold true. Third, vega falls as the option gets closer to expiration. In conclusion, we’ve only scratched the surface on these Greeks and it’s important to recognize that there are many nuances an option trader can get lost in when studying them. Luckily, there’s no reason to memorize the mathematics behind the Greeks, but knowing the variables that affect your diverse techniques can certainly help you plan for maximizing profits while mitigating risks. To gain better perspective of the positive and negative influences on bought and sold options, I suggest you review the Investopedia chart below.

Beau Keenan

 

Beau Keenan has been an active trader for six years. He graduated from BYU’s Marriott School of Business with a degree in corporate finance, but found his passion in trading. During that time he’s traveled the country coaching individuals on the markets and how to trade equities, options, futures and foreign currencies. He enjoys teaching and since joining the Traders Edge Network has personally worked with hundreds of individuals. Beau is a husband and father of two young children. He enjoys the freedom he has to do lots of other activities, from traveling to building businesses.

Musings from the Editor:
Meters Running…

When I started to write this month’s article roughly a week ago, my focus was firmly upon the U.S. broad indices. This should come as no surprise, as I’ve been hitting the issue hard in the last couple newsletters and the weekly blog posts out on Thursdays. And with good reason, given that the indices are seemingly stuck in a tight range… poised for what very much looks like a pretty important resolution workout—an inflection point that could well turn into a long-awaited breakout in either direction… sooner rather than later given the energy building in the coiling action of the past couple months.

Certainly some good meat to chew on, so all was well for me as I had largely finished my piece prior to this past weekend…just the need for some finishing touches and a good edit.

But as is often the case in life, the best laid plan goes askew and suddenly you find yourself walkin along a different path. Although it would be easier and less time consuming to stick with my original plan for this month’s article, upon reflection late this afternoon I realized that there might be a salient lesson to share involving my foibles…or at least a laugh at my expense.

The different path started last week innocently enough, when my Audi went back into the shop for the third time in the past two months…and for the umpteenth time in the past couple years. Ok, full-disclosure—the car has been in for literally dozens of visits beyond those called for under the routine maintenance schedule, not including a two-month stint for repairs related to an accident my “Ex” had in it during the first year I owned it.

Sooooo, at this point I’m gonna go ahead and concede the obvious–I’ve a love/hate relationship with that damn car… and I’ve allowed that dysfunction to blossom into a losing scenario. Yes, I’ve married myself to a losing stock and am hell-bent on trying to prove I’ve been right all along to hold rather than cut a loser and move on to something else. Believe me, those around me have enjoyed telling me time-and-again how misguided I’ve been…grrrrrr

Back to the present and many thousands of dollars later for this go-round, my car remains with Audi. While costly and certainly a thorn in my side, the situation was certainly not something to jump off the cliff over.

But fate has a sense of humor…as well as a keen sense of timing and a new twist in store for me, so it seems. Unbeknownst to me until after having filed a police report late this very morning after walking out to an empty parking space, I found out that the rental/ loaner that Audi had generously arranged for me (with my money) had in fact been towed from my complex Monday evening because it lacked my private parking permit—the very permit safely ensconced in the back window of my car—sitting in the Audi garage.

At that point I had certainly had my fill of surprises and wanted off the path on to which I had veered. Unfortunately, fate had one last card to play and it came in the form of the Rule of Three…there was indeed a third shoe to drop. I actually started the day optimistically due mainly to a favorable real-estate endeavor I had made an offer on first thing in the morning. Later in the afternoon, while standing outside the tow yard and listening to the attendant tell me they can’t release a rental car to anyone but the registered owner, I found out that my “sure thing” deal was suddenly not so sure.

As things stand now, my car remains in the Audi shop were the only thing running is the meter, the loaner is racking up fees (started at $300 but grows by the hour) in the hoosegow until the rental car company figures out what to do and my sweet real-estate deal has apparently gone south, although I can’t be sure because I’m unable to get a call back from my own representative in the deal…Doh!

So, what does this have to do with broad markets that I started out speaking about? Or anything market related, for that matter? Predictably, my answer at this point would normally be “dunno.” But in fact there is a connection which I’m getting to and you might just connect with…a common experience that actually takes a whole lot of
peeps out of the trading business…

Without going into further painful detail, the fact is I’ve broken all kinds of my own hard-learned rules with this car. Today was just the newest chapter, but I managed to make it a page-turner. I plowed forward with a lack of both information and awareness of my actual situation, armed with misguided assumptions and failing to understand I was operating blindly. Worse, as things started to work against me I failed to step back and play safe, as I am generally apt to do.

Any of this sounding familiar????

Fact is that a series of events largely beyond my control or awareness had been set in motion and were going to play out whether I wanted them to do so or not. My rash decisions and assumptions, exacerbated by the wrongheaded belief I could manage or change things through shear will, were conspiring against me to make the situation worse.

Gotta be some takers here…at least one or two trader out there who’ve fallen into this trap…

Throughout all of this, I was letting my anger rise and becoming more emotionally invested than I realized…I was pissed and wanting to take out my frustration and somehow vindicate myself and my actions.

Am I the only one that’s ever gone done this road? As is often the case when we allow ourselves to reach this point, I then doubled down on a losing bet and threw fire on the situatio —threatening the job of the tow company manager, who up to that point had agreed to substantially reduce the tow charge. She then promptly pulled her offer and instead tripled the charge by hitting me with everything she could legally. Certainly goes without saying that my approach was fool hearty and predictably doomed to failure. This was my desperationfueled “all-in” bet that I could make it all right with one action… You know what I’m talking about—the “I’m gonna get it all back with this one trade” approach. Hmmmm….Denial ain’t healthy…or a river runnin through North America…

Bottom line, I made mistakes at every turn and in so doing turned a manageable loss into something far greater…in fact I still don’t know what the final bill is going to be on this whole fiasco.

K, kidding aside, the fact is that nobody starts a day thinking they are gonna blow themselves up! As traders we all assume we are gonna fatten our wallets each day. After we’ve been around the block a time or two, we realize that some days we do and others we don’t, but that over the course of days/weeks/months/years we do fatten those wallets by consistently sticking to our plan, playing probabilities and always remaining disciplined. We learn to steer clear of situations capable of blowing us up…trades that start as manageable losses that inexplicably turn into disasters that imperil our ability to remain flush and in the game.

Cutting to the chase, many that enter trading never create a plan or rules…and they lose quickly. Lots more do establish a plan and rules, but they break them routinely…and they lose. Of the remaining group, some play loose with their rules at times…and they manage to stick around, but never profit to the extent they could. Those that do find themselves successful in this business
do something very unusual—they create a simple plan with simple rules…and they adhere to them!

As for my saga, I’m waiting to hear the damage and hopefully will pick up my car in the next day or so. As for the markets, hopefully we are gonna see that resolution move soon enough…something decisive enough to open this baby up and allow for some serious smack to be made. With the meter running still on both the loaner and the Audi, I’m gonna need it!

Louis Horkan
Editor

 

Louis entered the biz in the late 80s and spent over a decade working as a trader, instilling him with unique insight into trading and the markets. In 1998 he switched gears to become the group editorial director for a large network of award-winning, trading-focused newsletters. In 2002 he became the founding editor-in-chief for two financial trade magazines—each served approx. 40,000 independent financial advisers nationwide. He’s appeared on business TV, in the business press and on numerous biz-focused radio programs in the past. He writes market commentary and analysis most days and trades on a daily basis.