- 2000: Volume 9, No. 6 Translating the "Greeks" into Profits

Many times when you have conversations with options traders, you will notice that they refer to the delta, gamma, vega, or theta (otherwise known as the Greeks) of their positions. This terminology can be confusing and sometimes intimidating to those who have not been exposed to this type of rhetoric. When broken down, all of these terms refer to simple concepts that can help you to more thoroughly understand the risks and potential rewards of option positions. Having a comprehensive understanding of these concepts will help you to reduce your risk exposure, reduce your stress levels, and increase your overall profitability as a trader. Learning how to integrate these basic concepts into your own trading programs can have a powerful effect on your success as an options trader.

First, I would like to go over a couple of technical issues in regards to the Greeks. These are numbers that are calculated using higher-level mathematics and the Black-Sholes option-pricing model. The objective of this article is not to explain those computations, but to shed some light on the practical uses of these concepts. Additionally, I would suggest using an options software program to calculate these numbers so that you are not wasting precious time on tedious mathematics. Lastly, it is important to realize that these numbers are strictly theoretical, meaning that model values may not be exactly as calculated in a real-world situation.

Delta

The delta of an option is a measure of sensitivity of an option's theoretical value to a change in the price of the underlying stock. Another way to think about it is that the delta is the amount by which the price of an option changes for every dollar move in the underlying instrument. This is a very important number to consider when constructing combination positions. Call option deltas are positive (0 to 1.0) and put options have negative deltas (0 to -1.0). For example, if a call option has a delta of 0.5, then that implies that the option will increase by $0.5 for every $1.00 that the stock moves higher. Conversely, if a put option has a delta of -0.5, that implies that the option will increase by $0.5 for every $1.00 that the stock moves lower. Generally speaking, at-the-money options will have deltas of plus or minus 0.5, and deeper in-the-money options might have a delta of 0.8 or higher. Out-of-the-money options have deltas as small as 0.2 or less. These values will change as the option becomes further in or out-of- the money.

When an option is very deep in-the-money, it will begin to trade like the stock, moving dollar for dollar with the underlying stock. Far out-of-the-money options will not move much, even if the stock starts rising or falling. As a general rule, you should usually steer clear of buying options that are far out-of-the-money. Your chances of making money buying short-term out-of-the-money options are generally pretty small because the option's premium rapidly deteriorates; and you also need a large move in the right direction from the underlying stock in order to become profitable.

Gamma

Gamma can be defined as the rate of change in the delta for each one-point move in the underlying instrument. In other words, gamma is the degree by which the delta changes with respect to changes in the underlying instrument's price. The gamma is a valuable tool because it can help you forecast changes in the delta of an option or an overall position. For example, a gamma of +0.5 indicates the option will gain 0.5 deltas for each point increase in the stock price.

Vega

The vega of an option is the amount by which the price of an option changes when the volatility changes. As the volatility of a security increases so does the premium for its options. Volatility is one of the most important determinants of an options price, and the easiest way to understand volatility is to view a price chart over a period of time: The greater the price change, the higher the volatility.

Theta

The theta of an option is a measure of the time decay of an option. Theta can also be defined as the amount by which the price of an option exceeds its intrinsic value. Generally speaking, theta decreases as an option approaches expiration. Theta is one of the most important concepts for a beginning option trader to understand for it basically explains the effect of time on the premium of the options that have been purchased or sold. The less time that an option has until expiration, the faster that option is going to lose its value. The theta is a way of measuring the rate at which this value is lost. The further out in time you go, the smaller the time decay will be for an option. Therefore, if you want to own an option, it is advantageous to purchase longer-term contracts. If you are using 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.

These measurements can help you to explore the various risk exposures of every trade you are considering placing. Since options have a variety of risk exposures, these risks vary dramatically over time and as markets move. Often, it is not enough to know the total risk associated with an options position. For example, to create a delta neutral trade, you need to select a calculated ratio of short and long positions that together create an overall position delta of zero. To recognize the probabilities of the trade making money, it is essential to be able to determine a variety of risk exposure measurements. Changes in the price of the underlying instrument trigger changes in the delta, which trigger changes in all of the rest of the Greeks.

The Greeks help to provide important measurements of an option's risks and potential rewards. Once you have a clear understanding of the basics of the Greeks then you can apply this to your current strategies. Since prices are constantly changing, the Greeks provide traders with the means to determine just how sensitive a specific trade is to price fluctuations. Combining an understanding of the Greeks with the powerful insights risk profiles provide can help you take your options trading to another level.

Phillip Wiegand is a senior writer and options strategist for Optionetics.com