Importance of Greeks in Options Trading

Understanding the 4 main Greeks is key to evaluating any options position. Unlike stocks or forex, where only price changes are the main risk factor, options contracts have a multidimensional playing field and the variation of the underlying price, time passage, and implied volatility (or the volatility based on the options premium) will affect the options position risk. The easiest way to monitor each of these variables of risk is by checking your Greeks position (or portfolio) delivered by the option pricing model. When a trader manages his positions by the Greeks, he does not need to check charts or use technical indicators... curious? You can read more about it here. This type of trading is called Delta Neutral. In this trading methodology, the trader avoids directional risk by maintaining the Delta close to 0. The profitability comes from options contract time erosion of volatility changes. I am trading Delta Neutral in my proprietary options strategy Ride Trade. Trading options involves constant monitoring of all the Greeks!

What is Delta?

It’s important to have realistic expectations about the price (or option premium) behavior of an option contract given variations in the price of the underlying. This will give you an idea about how much will the price of an option move if the underlying moves $1 (maintaining other variables constant) Delta is defined by the amount an option price is expected to change given a $1 change in the underlying asset.

 

Calls and Puts

Calls have a positive delta, between 0 and 1. That means if the underlying security price goes up and no other variables change (like implied Volatility and time), the price for the call should go up. If a call has a delta of .50 and the underlying goes up $1, in theory (given other variables static), the price of the call will go up $.50. If the underlying goes down $1, the opposite will happen – call price will go down about $.50.

Puts have a negative delta, between 0 and -1. That means if the asset goes up and no other variables change, the price of the option will go down; if a put has a delta of -.50 and the underlying goes up $1, the Put price will go down $.50; again, if the asset goes down $1 the price of the put will go up $.50.

 

Dynamics

As a general rule, in-the-money will move more than out-of-the-money, and shorter-term options will react more than longer-term options to the same price change in the underlying security.

As expiration nears, the delta for in-the-money calls will approach 1, reflecting a one-to-one reaction to stock price changes. This means it is similar to owning that stock. Delta for out-of the-money calls will approach 0 and won’t react much to minor price changes in the asset. That’s because if they are held until expiration, calls will either be exercised and “become underlying” or they will expire worthlessly and become nothing at all. As expiration approaches, the delta for in-the-money puts will approach -1, and the Delta for out-of-the-money puts will approach 0. That’s because if puts are held until expiration, the owner will either exercise the options and sell underlying (in the first case) or the put will expire worthless (for the latter). 

 

Delta as probability

But Delta also has another interpretation: the probability of an option will be in-the-money at expiration, which means delta could be understood as a probability measure. An at-the-money call option will have a delta of about .50, or “50 deltas.” That’s because there should be a 50/50 chance the option winds up in- or out-of-the-money at expiration. As an option gets further in-the-money, the probability it will be in-the-money at expiration increases, and hence, the option’s delta will have a higher value. On the contrary, as an option gets further out-of-the-money, the probability it will be in-the-money at expiration decreases and will have a lower delta.

In short,

Delta is the Greek letter that signifies directional exposure. It can also be used to (1) determine the equivalent number of shares and (2) estimate the probability of the option to expire in the money. In essence, it delivers the rate of change of an option’s price, given a $1 increase in the underlying price. Positive Delta strategies gain if the underlying price increases. In contrast, strategies that have negative Delta gain if the underlying price decreases. If an option has 20 Delta, it means that it has a circa 20-percent probability to end in-the-money.

Delta neutral strategies or portfolios refer to overall options positions that have a total Delta value of about 0 and are fairly neutral to the underlying price movements.

Calls have positive Deltas, and puts have negative Deltas.

 

 

What is Gamma?

Gamma is the greek that gives an understanding of how Delta will change when the underlying moves. It is literally the rate of change of an option’s delta, given a $1.00 move in the underlying. For example, if a long call option has a gamma of 0.10 and a delta of 0.50, and the underlying moves up $1.00, the option will then have a delta of 0.60, all else equal. There are a few important concepts when it comes to gamma: Long option benefits, and short options have increased Gamma risk. It will increase as we approach the expiration date.

 

Long Option Benefits of Gamma

Gamma is the friendliest to long option holders. It accelerates profits for every $1.00 the underlying moves in our favor and decelerates losses for every $1.00 the underlying moves against us. Since delta is the rate of change of an option’s price, and gamma increases an option’s delta as it moves closer to, or further in the money, in the example above the delta would just continue to increase. Every dollar the underlying increased would result in more and more efficient returns on the investor's capital. This phenomenon also decelerates losses, as it works in the opposite way for every $1.00 the underlying moves against us.

 

Short Option Risks of Gamma

Because it can be beneficial for option buyers, that must mean that it can be risky for option sellers. From the seller’s perspective, it can accelerate losses, and decelerate directional gains. It is just the opposite side of the coin from the example above.

 

Expiration Risk & Gamma

The final aspect of gamma that is important to realize is expiration risk. As we get closer to expiration, our probability curve gets much narrower (or steep). There is not a lot of time for the underlying to move to our far OTM strikes, and they will have a lower probability of being ITM because of that. Since we know the probability curve is narrower, that also means our delta distribution is narrower. The result is a more aggressive gamma. This can be good for option buyers, but especially bad for option sellers. It can quickly turn winning trades into losers or losing trades into winners. I prefer to avoid these drastic swings, which is just another reason why I do not keep positions until expiration; in fact, I tend to close them before 7 days to expiration.

 
In short,

Gamma is the Greek letter signifying the rate of change of an option’s Delta, given a move in the underlying. Long option positions benefit from increasing Gamma. It is said that these positions are positive Gamma. As you approach the expiration point, Gamma increases, which means Delta variations are more pronounced to lower-price movements of the underlying due to the steepness of the probability curve. It can quickly turn winning trades into losing ones and vice versa. It is preferable to avoid these drastic swings, which is the reason not to have open positions 7 days prior to expiration.

 

Gamma is beneficial to long option holders. It accelerates profits for every move of the underlying in traders’ favor and decelerates losses for every move the underlying goes against. In contrast, Gamma is extra-risky for traders that are selling options premium. From the sellers’ perspective, it can accelerate losses and decelerate directional gains.

What is Theta?
 

Time decay, or theta, is the number one enemy for option buyers. On the other hand, it’s usually the option seller’s best friend. Theta value is the amount the price of calls and puts will decrease or increase (at least in theory) for a one-day change in the time to expiration.

In the options market, the passage of time is similar to the effect of the hot summer sun on a block of ice. Each moment that passes causes some of the option’s time value to “melt away.” Furthermore, not only does the time value melt away, it does so at an accelerated rate as expiration approaches.

An at-the-money 90-day option with a premium of $1.70 will lose $.30 of its value in one month. A 60-day option, on the other hand, might lose $.40 of its value over the course of the following month. And the 30-day option will lose the entire remaining $1 of time value by expiration.

At-the-money options will experience more significant dollar losses over time than in- or out-of-the-money options with the same underlying and expiration date. That’s because at-the-money options have the most time value built into the premium. And the bigger the chunk of time value built into the price, the more there is to lose.

Keep in mind that for out-of-the-money options, theta will be lower than it is for at-the-money options. That’s because the dollar amount of time value is smaller. However, the loss may be greater percentage-wise for out-of-the-money options because of the smaller time value. Having negative theta means we are trading against the clock. The extrinsic value of our options will dissipate over time, which means we have to be directionally right quickly in order to see a profit, or we need implied volatility to expand more than theta will decay the option. This is why we always hedge our long options with a short option. It is preferable long vertical spreads, calendar spreads, and diagonal spreads, compared to long naked options, because we can eliminate a lot of time decay.

 
In short,

Theta value signifies the daily decay of an option’s extrinsic value, assuming other variables are constant. If a position has positive Theta, it will increase value as time passes and is possible only if we sell options. For option sellers, Theta decay is a good thing. 

If a position has negative Theta, it will lose value as time passes. Negative Theta is achieved when options bought outpace the options sold.

The extrinsic value of options will decrease as we approach expiration, which means we have to be directionally right and quick or implied volatility to increase in order to see a profit.

What is Vega?
 

Vega is the amount call and put prices will change, all other variables constant, for a corresponding one-point change in implied volatility. Vega does not have any effect on the intrinsic value of options; it only affects the “time value” of an option’s price. Vega values represent the change in an option’s price given a 1% move in implied volatility, all else equal. Long options & spreads have positive vega. Example strategies with long vega exposure are calendar spreads & diagonal spreads. Short options & spreads have negative vega. Some examples are short naked options, strangles, straddles and iron condors.

 

When thinking about Vega, we have to remember that implied volatility is a reflection of the options premium action in the options market (it is not the historical volatility, which reflects price variations and measured by standard deviation). When option prices are being bid up by people purchasing them, the implied volatility will increase. When options are being sold, implied volatility will decrease. With that said, when being long options we want the price of the option to increase. When being short options we want the price of the options to decrease. That is why long options have a positive vega, and short options have a negative vega. An increase in implied volatility will benefit the long option trader, as that indicates an increase in option pricing. A decrease in implied volatility will benefit the short option trader, as that indicates a decrease in option pricing.
 

Since we normally hold a short vega portfolio as option sellers, we are exposed to volatility increases. We have to be careful with this exposure as volatility generally has the velocity to the upside. This means volatility can quickly spike up, as it usually has a negative correlation with the market, which tends to have a slower velocity to the downside. Managing our vega is important to ensure that we don’t have more exposure than we’re comfortable with from a portfolio perspective.

 

Vega is the Greek letter signifying the value of options given changes in implied volatility. Vega values represent the change in an option’s price, given a 1 percent move in implied volatility, all else being equal. Long options have positive Vega and will benefit if implied volatility increases. When option prices are being bid up by people purchasing them, implied volatility increases. When options are being sold, implied volatility will decrease. Long options positions have a positive Vega and short options have a negative Vega. An increase in implied volatility will benefit the long option positions, as that indicates an increase in option prices; hence, the positive Vega. On the contrary, a decrease in implied volatility will benefit the short-option holder, as that indicates a decrease in option pricing, hence negative Vega.