- 1997: Volume 6, No. 1 Are Options "Greek" To You?

No trader can ignore the flexibility of stock and futures options. Options are almost limitless in their variation for reducing risk of an established position or profiting from new positions.

Ask yourself: what are some of the most profitable businesses in the world? The Mirage, The Taj Mahal, Prudential, UNUM, etc. You might be saying "what does the mention of casinos and insurance firms have to do with options trading?" The relationship between Las Vegas, Lloyds of London, and successful options trading is very tight.

Take for example the recent Tyson-Holyfield fight. The Vegas bookies will typically pay out $90 of every $100 they take in. Bookmakers don't care who wins the fight because they make money no matter who wins. They earn a "commission" on each side of the equation. A commission that doesn't care about market direction. Bookmakers are looking for a range of bets on both sides to hold steady.

These strategies are not new. Floor traders from Chicago to Singapore make their daily bread all day long with techniques the best casinos or insurance houses could only dream of. Good traders just like insurance and casinos, don't care about directions, they want steady ranges that grind out profits every day.

The Greeks
The "Greeks" are a must for basic option understanding. Without drifting into the arcane language of an options pricing model, a brief primer is wise:

Delta
Delta is the change in premium over change in the underlying. If a stock or future moves $1, the call or put $.50, the delta is .50.

Gamma
Gamma is the change in delta over change in the underlying. If a stock or future moves $1, the delta is $.05, the gamma is .05.

Rho
Rho is the change in option price over change in the risk-free interest rate. For Europeans (non-dividend options), as rates increase, call values increase; put values decrease.

Theta
Theta is rate of option decay, day to day, all other things being equal. The Theta accelerates near expiration.

Vega
Vega shows how much an option price changes per 1% change in volatility. If volatility changes by 1% and the option changes by .20, vega is .20.

In time, these ratios become second nature. Don't feel intimidated!

The Delta

Options on futures can be a difficult tool to master. Imagine this example: a speculator purchases an option, expecting the price of the option to increase as the price of the underlying futures contract goes in the desired direction. More times than not though, this does not happen as quickly as it should to earn the profit expected. This unexpected lag time is crucial to understand. The "Delta" is the key. Mastery of this important concept is crucial for options traders or investors.

What is the Delta?

The Delta measures the rate of change in the option price with respect to the price of the underlying. For example, you recently purchased a call option and today the underlying futures position moved 10 points in your favor. Your option price moved two points. Therefore the Delta on your option is a .20. Mathematically, the Delta formula is determined by the change in option price divided by the change in the underlying futures price. A Delta of .20 means that your option premium should move 20% of what the underlying future moves.

It is important to remember that the Delta is a moving target. For instance, as your option moves closer to its strike, or moves closer to going into the money, your Delta will increase. A linear representation of the Delta allows you to see the association of the market price and the Delta of the option.

Out of the money:

Delta approaches 0

At the money:

Delta .50

In the money:

Delta approaches 1.0

The Delta can be summed up as a representation of the rate of change in the option premium. A Delta of .20 in the above instance would realize a 20% increase in the price of the option with a favorable move in the underlying futures. With this in mind, a Delta of .20 means that you are net long by .20 of a futures. Hence your bias on the market is bullish.

Trading with the Delta

The Delta can be a fantastic trading tool for squeezing profits out of the markets. For example, if you are bullish on the market and wish to risk a certain pre-defined amount of capital, options strategies may be the most flexible tool the investor has in his arsenal. What is a better alternative in this example: (1) purchasing many deep out-of-the-money options at apparently cheaper prices or (2) purchasing few close to or in-the-money options at apparently more expensive prices.

In this example, it is more important to control how much or how little your option will appreciate or depreciate than the size of your position. Remember, we are trying to limit ourselves to a set amount of capital usage or loss.

The investor should purchase close-to-the-money options, knowing that if he is right, the premium will appreciate more rapidly than the out-of-the-money options. This is because the delta on the close-to-the-money options is greater than the delta on the out-of-the-money options.

Another Delta Strategy

Recall that the Delta measures the bias that you have on the market. For instance a positive Delta would indicate that you have a bullish stance on the market. If you have a Delta of 0, your bias is neutral. A Delta of 0 should mean that you do not have a particular stance on the market at that time.

A Delta of zero has given rise to what has become known as "Delta Neutral" options trading. This type of trading allows the investor to not concern himself with market direction to a certain extent, but rather the trader aims to predict the range that a market will stay between.

Take the following example of placing two bets on the altitude of an airplane. You make the predictions that the airplane will have an altitude of more than 5,000 feet and less than 20,000 feet. As long as the airplane stays in an altitude that is between these two numbers, both of your bets make money. Now lets say the airplane goes to 20,000 feet and is climbing. Once the plane went over the 20,000 ceiling you lost your bet on the 20,000 feet altitude part, but you profited from the 5,000 foot bet. At this point you can simply re-adjust, or place a new wager based upon the new information that the airplane has given you. You can now place a new bet to say that the airplane will not go above 30,000 feet, thereby expanding the range of your position to be between 5,000 feet and 30,000 feet.

This same type of procedure can be applied to most futures and stock markets. Simply replace the altitude of the airplane with the market price of a commodity or stock. Take T-bonds as an example. T-bonds arecurrently trading near 114.00 and you believe that the bonds will stay in a range between 106.00 and 118.00. Therefore you place a trade that predicts the range of the Bonds to stay between those two prices. If the price of Bonds rallies and goes to 118.00 then you can readjust the position so that your range prediction is now 106.00 and 120.00.

The proper usage of the Delta is crucial to profit from a trading range given in the above example. To deviate from Delta Neutrality is to incur greater risk.

Conclusions

There are a limitless array of possible option trading strategies and we have only briefly examined "Delta." Never lose sight of the fact that options are multi-dimensional. They are usually not only "directional plays" that involve the simple purchase of an option as you would purchase a share of IBM.

Options can be traded from the view of many dimensions, one dimension or a pre-specified combination of dimensions. However, no matter which angle you trade off, all factors will most likely affect your trading success. These many facets of an option are never static and a change in one will quickly change another.

Above all the options trader should remember that nothing can stop the passage of time.

J. Chadwick Vandergrift is Director of Systems Research for www.turtletrader.com. Interested parties can learn more by visiting the Tutrtle Trader web site at: www.turtletrader.com