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.