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Today's Featured Article
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INTRO
An Option's price is constantly being influenced by several factors. In the trading community they call these factors, Greeks. In order to become a successful options trader, it is essential to master how each Greek affects the option's price. Each Greek measures the value of an option according to how sensitive it is to certain variables.
UNDERSTANDING THE GREEKS
The Greeks are utilized in trading to help determine how certain variable will affect an option theoretical value.
Unfortunately, in the marketplace, the underlying asset and the options do not always react the same way. In other words, options do not have a linear relationship with the underlying asset. Therefore, the Greeks are used by traders to shed light into the way the option has been affected by a change in the underlying futures contract.
Another great feature offered by Greeks is the ability to analyze multi-legged option positions. By simply looking at the Greeks of the total position or spread, a trader knows exactly where their risk or reward potential lies.
THE FOUR GREEKS:
Delta - measures the change in an option's price (premium of an option) resulting from a change in the underlying futures contract.
Gamma - measures the rate of change of delta.
Theta - measures the rate of decline of time-premium resulting from the passage of time.
Vega - measures risk exposure to implied volatility changes
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THE DELTA
Delta is a measure of the change in an option's price (premium of an option) resulting from a change in the underlying futures contract.
The value of delta ranges from -- 100.0 to 0 for puts and 0 to 100 for calls.
Puts have a negative delta because they have what is called a "negative relationship" to the underlying: put premiums fall when the underlying rises, and vice versa.
Call options, on the other hand, have a positive relationship to the price of the underlying futures contract: if the underlying asset rises, so does the premium on the call, provided there are no changes in other variables like implied volatility and time remaining until expiration. And if the price of the underlying falls, the premium on a call option, provided all other things remain constant, will decline.
An at-the-money option has a delta value of approximately 50 (0.5 without the decimal shift), which means the premium will rise or fall by half a point with a one-point move up or down in the underlying futures contract.
For example, if an at-the-money wheat call option has a delta of 0.5, and if wheat makes a 10-cent move higher (which is a large move), the premium on the option will increase by approximately 5 cents (0.5 x 10 = 5), or $250 (each cent in premium is worth $50).
- Delta tends to increase as you get closer to expiration for near or at-the-money options.
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Delta is not a constant, a fact related to gamma, our next risk measurement, which is a measure of the rate of change of delta given a move by the underlying.
- Delta is subject to change given changes in implied volatility.
THE GAMMA
Gamma, also known as the 'first derivative of delta', measures the rate of change of delta. This is a simple concept to grasp. When call options are deep out of the money, they generally have a small delta. This is because changes in the underlying bring about only tiny changes in the price of the option. But as the call option gets closer to the money, resulting from a continued rise in the price of the underlying, the delta gets larger.
- Gamma is smallest for deep out-of-the-money and deep in-the money options.
- Gamma is highest when the option gets near the money.
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Gamma is positive for long options and negative for short options.
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THE THETA
Theta is use often by both options buyers and sellers, but it is especially used by option buyers. Theta measures the rate of decline of time-premium resulting from the passage of time. In other words, an option premium that is not intrinsic value will decline at an increasing rate as expiration nears.
- Theta can be very high for out-of-the- money options if they contain a lot of implied volatility.
- Theta is typically highest for at-the-money options.
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Theta will increase sharply in the last few weeks of trading and can severely undermine a long option holder's position, especially if implied volatility, which I discuss next, is on the decline at the same time.
THE VEGA
Vega, our fourth and final risk measure, quantifies risk exposure to implied volatility changes. Vega tells us approximately how much an option price will increase or decrease given an increase or decrease in the level of implied volatility. Option sellers benefit from a fall in implied volatility, and it's just the reverse for option buyers.
- Vega can increase or decrease even without price changes of the underlying because implied volatility is the level of expected volatility.
- Vega can increase from quick moves of the underlying, especially if there is a big drop in the stock market, or if there is a sudden upwards burst in a commodity like coffee after a reported frost in Brazil.
- Vega falls as the option gets closer to expiration.
SUMMARY
The Greeks, when used properly, can be a very powerful tool to analyze multiple risk statistics and how they can affect option pricing. As a trader is essential to know the true risk and reward potential of an option, the Greeks, in more then one way, offer that valuable information.
It is OpVest's recommendation that you study the concepts covered in this 'Quick Guide' and try to apply them as often as you can. If this is your first time being introduced to the Greeks, then please remember, like anything in life, it may take time to comprehend all the nuances that come with concepts such as these.
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About the Author
Steve Salman was born in Montreal, Canada and raised in beautiful southern California. Growing up he watched his father buy lumber for the family furniture business. By 18 years of age, Steve knew the spot prices for Mahogany, Walnut, and Oak. Naturally this led him to his life passion for trading.
Today Mr. Salman is a registered CTA for Avalon Capital Advisors and a branch manager for OpVest. He has been trading for over 15 years and has done everything from being a currency specialist, bond trader, to an options educator. With today's market conditions, Steve believes diversification and proper money management are required to be a successful trader. Steve currently holds a series 3 and 30 along with being a registered CTA.
Ssalman@opvest.com | |
Special Message from Our Author
Invest with a New Perspective: OpTrak Weekly from OpVest
Sign up now to receive a COMPLIMENTARY 30-day subscription to the OpTrak Weekly Newsletter from OpVest. OpTrak Weekly is an acclaimed in-depth newsletter that utilizes an award winning advanced option analysis software program and proprietary models to identify and design trades. Each issue includes Market Commentary, Trading Plans, Greek Analysis and Volatility Graphs.
Start Your Complimentary Trial Today!
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