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Understanding the Greeks in Option Trading Because an option premium does not always appear to move in conjunction with the price of the underlying asset, it is important to understand the other factors that contribute to the movement of an option’s price. Options traders often refer to the Delta, Gamma, Vega, and Theta of their positions. Collectively, these terms are known as the “Greeks” and they provide a way to measure the sensitivity of an option’s price to quantifiable factors. These terms can be confusing and intimidating to new option traders, but broken down, they refer to simple concepts that can help you better understand the risk and potential reward of an option position. They cannot be looked up in your everyday option tables, but OptionVue 5 automatically does the calculations and gives you this information for every option and position you look at. You can see the Greeks for each individual option by selecting them for display in the Matrix. The Matrix below is formatted to show the delta, gamma, theta, and Vega for every option on Cisco Systems:
Notice that the summary section
automatically includes the current Delta, Gamma, Theta, and Vega for your
total position in this asset.
Now that we know where to find the Greeks in OptionVue 5, let’s
define what each one represents in detail. Delta measures the sensitivity of an
option's theoretical value to a change in the price of the underlying
asset. Delta is a very
important number to consider when constructing combination positions. Call options have positive deltas
and put options have negative deltas. At-the-money options generally
have deltas around 50. Deeper
in-the-money options might have a delta of 80 or higher. Out-of-the-money options have
deltas as small as 20 or less.
Delta will change as the option becomes further in or out-of- the
money. When a stock option is
deep in the money, it will begin to trade like the stock - moving dollar
for dollar with the underlying stock, while the far out-of-the-money
options don’t move much.
Since Delta is such an important
factor, the marketplace is interested in how Delta changes. Gamma measures the rate of change
in the delta for each one-point increase in the underlying asset. It is a valuable tool in helping
you forecast changes in the delta of an option or an overall
position. Gamma is largest
for the at-the-money options, and gets progressively lower for both the in
and out-of-the-money options.
Unlike Delta, Gamma is always positive for both calls and
puts. In OptionVue 5, Delta and Gamma are
normalized for dollars for all non futures-based options and represents
the dollar amount you will theoretically gain or lose with a one–point
increase in the underlying.
For futures options, delta and gamma are not expressed in dollar
terms. They represents an
equivalent number of futures contracts times 100. For example, if an at-the-money
option moves ½ point when the underlying futures contract moves 1 point,
delta for that option will be .5 X 100 = 50. If you were long two such options,
you would have a delta of 100, which indicates the equivalent of being
long one futures contract. Delta and Gamma change
constantly. Factors that
affect Delta and Gamma include time, the price of the underlying, and
volatility. Since Delta
measures the slope (first derivative), and Gamma the curvature (second
derivative), of the risk graph at a single point, volatility is a critical
input. OptionVue 5 allows you
to choose between the standard model for Delta and Gamma, or True
Delta and Gamma. Since any
change in the price of an underlying asset will be accompanied by a change
in volatility, True Delta and Gamma takes this volatility shift into
account. The result is a more
accurate picture of the behavior of an option. OptionVue 5 automatically defaults
to True Delta and Gamma, although you can choose to use standard Delta and
Gamma in the model section of each Matrix, or system-wide under View |
Default Model in the main menu.
The next Greek we will look at is
Vega. Many people confuse
Vega and volatility.
Volatility measures fluctuations in the asset itself. Vega measures the sensitivity of
the price of an option to changes in volatility. Changes in volatility affect calls
and puts and in a similar way.
An increase in volatility will increase the prices of all the
options in an asset, and visa versa.
However, each individual option has its own Vega and will react
differently. The impact of
volatility changes is greater for at-the-money options than the in or
out-of-the-money options.
While Vega affects calls and puts similarly, it seems to affect
calls more than puts. Perhaps
because of the anticipation of market growth over time, this effect
becomes more pronounced for longer-term options, especially LEAPS.
Finally, Theta is a measure of the
time decay of an option. It
is the dollar amount that an option will lose each day. For at-the-money options, Theta
increases as an option approaches the expiration date. For in and out-of-the-money
options, theta decreases as an option approaches expiration. Theta is one of the most important
concepts for a beginning option trader to understand, because it explains
the effect of time on the premium of the options that have been purchased
or sold. The further out in
time you go, the smaller the time decay will be for an option. If you want to own an option, it
is advantageous to purchase longer-term contracts. If you want a strategy that
profits from time decay, then you will want to be short the shorter-term
options, so that the loss in value due to time happens quickly. The Greeks can help you quantify the
various risks of every trade you are considering. It is important to realize that
these numbers are strictly theoretical, meaning that the values are based
on the mathematical models.
Since options have a variety of risk exposures, these risks vary
dramatically over time and as markets move. As we saw earlier, the current
Greeks are given in the Matrix for every option and position. OptionVue 5 also predicts what
will happen to the Greeks over the life of a trade in the Graphic Analysis
screen. Once you choose a
prospective trade, click on the Analyze button:
Here I have chosen a simple bull
call spread using the June 15 and 17.5 calls and clicked on the 25 day
line, halfway between today and the expiration date. The table underneath the graph
shows the predicted profit/loss, Delta, Gamma, Theta, and Vega for the
position at various prices of Cisco stock. To change the date of the lines in
the graph, right-click on the line legend box (or the projected date box)
and put in the date you are interested in seeing. To change the scale and center
point of the horizontal (price) axis, right-click anywhere in the
graph. The Greeks help to provide important measurements of an option position’s risks and potential rewards. Once you have a clear understanding of the basics, you can begin to apply this to your current strategies. It is not enough to just know the total capital at risk in an options position. To understand the probability of a trade making money, it is essential to be able to determine a variety of risk exposure measurements. Changes in the price of the underlying asset trigger changes in delta and all the rest of the Greeks. Since prices are constantly changing, the Greeks provide traders with a means of determining just how sensitive a specific trade is to price fluctuations, volatility fluctuations, and the passage of time. Combining an understanding of the Greeks with the powerful insights the risk graphs provide can help you take your options trading to another level. * Option strategies carry inherent risk of large potential losses. As such, these strategies may not be suited to every investor. |
