The Greeks and Options Trading

The Greeks

When people start investing in options, most are very intimidated by the Greeks. You will learn, as I did, that you’re not entirely prepared for options investing until you acquire a basic knowledge of the Greeks. Understanding the Greeks is crucial to options investing because they allow us to have a mathematical understanding of our positions and gauge our true risk. They’re not the end all be all. Don’t give up on options if the Greeks seem too complicated. I know plenty of people who have no understanding of the Greeks but do very well trading options. However, the Greeks do give you an edge. If you can understand the relationship between each Greek and the underlying security, you will be ahead of the game.

 

The Importance of Knowing the Greeks

 When I started learning how to trade options, someone gave me a great analogy that summed up the importance of the Greeks. He said, “Trading options without an understanding of the Greeks is like flying a plane without the ability to read instruments.” Many traders are not “instrument rated.” They do not know how to read the Greeks when trading. That puts them at risk of a fatal error, much like a pilot trying to fly in a storm without the benefit of a panel of instruments. Greeks measure the sensitivity of the option price to quantifiable factors. They can help you better understand the risk and potential reward of an option.

 

The Ins and Outs of Options Greeks

 The values for the Greeks are heavily influenced by how close they are to the strike price, so it is worthwhile for new options investors to go over some related terminology. If you already have some experience with options, you might want to skip this and go straight to breaking down the Greeks.

A call option allows you to buy a security, such as a stock or an ETF, at the strike price. When the security price is below the strike price, the call is said to be out of the money (OTM). Options also have an expiration date, and options that expire OTM are worthless. An option where the security price is the same as the strike price is said to be at the money (ATM). Many of the Greeks are most powerful ATM. When the security price is above the strike price, the call option is said to be in the money (ITM). An ITM call option has an inherent value equal to the difference between the security price and the strike price, and the Greeks determine the rest of the option’s value.

Similarly, a put option allows you to sell a security at the strike price. Naturally, a put is out of the money (OTM) when the security price is above the strike price and in the money (ITM) when the security price is below the strike price.

 

Breaking Down the Greeks

 With that said, let’s break down the Greeks. The most important are Delta, Gamma, Vega, Theta, and Rho.

 

Delta (the speed of the option)

First, let’s explore Delta. It measures how an option’s price changes due to the change in the price of the underlying stock. More precisely, it measures the sensitivity of an option’s theoretical value to a change in the price of the underlying asset.

Delta can be thought of as the probability that an option will expire in the money (ITM). Delta is important for investors because options that do not expire ITM end up being worthless. For example, suppose that a call option has a Delta of 0.20, then that option has a 20% chance of being in the money at expiration. Delta is always positive for calls because the probability that the price of the underlying security ends up higher than the strike price increases as the price of the security increases. Similarly, the Delta value is always negative for puts. Naturally, the probability that a put with a Delta of -0.20 expires ITM is 20%.

An essential characteristic of Delta is that it goes further away from zero as the option goes deeper into the money. Think about this logically. The more the option is in the money, the more likely it is to be exercised. So, options with a high enough Delta change in value exactly as the stock does. If stock XYZ trades at $44 per share, then the September 45 calls will have a higher Delta than the September 55 calls because the September 45 calls are closer to the money and more likely to be exercised. For puts, this is reversed. September 40 puts would have a Delta further away from zero than the September 35 puts because the September 40 puts are closer to the money and more likely to be exercised.

Delta can also be seen as your percentage exposure to the underlying stock. From this point of view, being long or short a stock is the most bullish or bearish you can be. The stock itself has a Delta of 1, so your exposure is 100% when you buy the stock. If you were to buy a call with a Delta of 0.70, you would only be exposed to 70% of that stock’s movement. You would only make $0.70 if the stock jumped $1, but you would lose just $0.70 if the stock fell by $1.

Delta is not static, and you can think of it as the speed of the option. Delta is the speed gauge on your plane’s instrument panel! Suppose that you purchase a call with a Delta of 0.70. If the stock drops $1, then your new Delta might drop to 0.60. Your loss rate slows down. It works in the other direction as well. Assume that you bought a call with a Delta of .70, and then the stock rose $1. Your call might then have Delta of 0.80, accelerating your profits. Gamma can be interpreted as the acceleration of the option, so that is where we will turn next.

 

Gamma (acceleration of the option)

Gamma is the change in the option Delta due to a one-point move in the underlying security. It is usually expressed as a percentage. Gamma tells traders the sensitivity of their positions to directional movements. Gamma is similar to Delta in that the smallest uptick or decrease in the underlying stock price can affect it. Personally, I like Sheldon Natenberg’s description of Delta as the speed of the option and Gamma as its acceleration.

Positions with Gamma numbers further away from zero are usually considered more dangerous. Some firms even set Gamma limits for their options traders, so you should pay attention when Gamma gets large. On that same note, a Gamma number close to zero indicates a low degree of risk.

Gamma is also a useful tool for forecasting changes in the Delta of an option or constructing your overall position. Gamma is identical for calls and puts that have the same strike price, and Gamma is always positive for options. So, you are long Gamma when you buy options. To short Gamma, you must sell options. Additionally, understanding Gamma can help you to hedge Deltas because low Gamma positions require less maintenance than high Gamma positions.

There are a several important factors to keep in mind when dealing with Gamma. Gamma values are highest for at the money (ATM) options and lower for in the money (ITM) and out of the money (OTM) options. Gamma for options that are close to the money increases dramatically as the expiration date approaches. When it comes to volatility, Gamma mostly affects options that are at the money. When volatility is low, at the money options tend to have high Gammas. Volatility brings us to Vega.

 

Vega (volatility response)

Vega measures the change in the option price due to a change in volatility. Vega is identical for calls and puts because volatility affects them in the same way. An increase in volatility will increase the price of all options on an underlying stock, while a decrease in volatility will reduce the value of the options.

Vega is very important for new options investors who are usually too focused on prices to pay much attention to volatility. When Vega is high for an option and volatility is also high for the underlying security, that should be a red warning light not to buy. You are learning to read your instrument panel now!

There are a few essential factors that determine Vega. At the money (ATM) options are always the most sensitive to changes in volatility, so Vega increases as you get closer to the money. Vega declines as the expiration date approaches. Long-term options are always more sensitive to changes in volatility than short-term options.

Vega is particularly helpful when looking at options that are at the money, which are typically very sensitive to volatility. Consider that the Vega of an option expresses the change in the price of the option for every 1% change in underlying volatility. For example, If you look at an option chain and find an option with a Vega of 0.20, this means that the value of the option will increase roughly $0.20 with a 1% rise in volatility and will lose 0.20 with a 1% decrease in volatility. Vega is not static and will change throughout an option’s life, so you need to monitor it.

Finally, you can turn Vega to your advantage when you become more sophisticated. The low volatility in the stock market during much of 2017 made long-term calls a much better bargain than usual because of Vega. However, volatility is likely to return eventually. High Vega can help you when selling options. For example, you can sell a put spread with high Vega when volatility is high and repurchase it after volatility dies down. You can certainly afford to wait because time works for you when you sell options.

 

Theta (time decay)

That brings us to Theta. It is a measurement of the time decay of an option, which is the dollar amount that an option will lose each day due to the passage of time. I learned another way of looking at Theta from an options trader friend of mine. Theta is like rent; you will either be paying it or collecting it.

Like Vega, Theta is often overlooked by new options investors. Theta is always negative for both calls and puts. That means that all options lose value with the passage of time. The only way to benefit from Theta is to sell options rather than buy them. Selling covered call options on SPY has historically outperformed the S&P 500.  Collecting rent by selling options is usually more profitable than paying it by buying options. What do most novice traders do? They buy options.

Theta is primarily influenced by the time to expiration. Although Theta is higher for out of the money (OTM) options that are far from their expiration date, it increases much more rapidly for at the money (ATM) options as expiration approaches. Theta is dramatically higher for ATM options near the expiration date than for any other type of options.

The great lesson to be learned from Theta is that it is usually better to sell options with high Theta and buy options with low Theta. An easy and typically profitable way to do that is to sell short-term puts and only purchase long-term calls when volatility is low.

 

Rho (rising rates response)

Rho measures the change in the option price caused by an increase in interest rates. More specifically, Rho is the sensitivity of an option’s theoretical value to a change in interest rates.

After years of near-zero interest rates, Rho is becoming important again as interest rates go up. In general, Rho is positive for calls and negative for puts. Rho is always further from zero for long-term options because they are more sensitive to interest rates, just as long-term bonds are more sensitive to interest rates. Out of the money (OTM) options also have Rhos further from zero than at the money (ATM) or in the money (ITM) options.

By being aware of Rho, you can make interest rate increases work for you in the options market. Very few investments benefit from interest rate hikes. On a cautionary note, 2017 was an unusually good year for Rho based strategies.

 

Conclusion

Remember, the Greeks move based on continually changing conditions. They depend on the distance of the strike price from the price of the security and how much time is left before the options expire. By understanding and using the Greeks, you can improve your risk management skills and learn to make investments with a better risk-reward profile. Better risk management helps you to achieve your ultimate goal: making money more consistently.

 

The Greeks – Quick Reference

Delta: the change in the option price due to a change in the underlying security price, the speed of the option

Gamma: the change in the option Delta due to a change in the underlying security price, the acceleration of the option

Vega: the change in the option price due to a change in volatility

Theta: the change in the option price due to the passage of time, also called time decay

Rho: the change in the option price due to a change in interest rates