At first glance, trading stock options may seem straightforward if you have a general understanding of trading stocks. Unfortunately, stock options is very deceptive and traders could easily fall into the trap of buying options without understanding the factors that affect their price. Rookie investors can make the mistake of buying out of the money (OTM) options with zero intrinsic value or too close to expiration. Options trading can become so convoluted if you don’t have a solid foundation. Option Greeks is one of the pillars of options trading foundation. By understanding the Greeks, traders will be better equipped in selecting strike prices for calls or puts, managing risk, and increasing overall profit potential.
How are the Greeks Generated?
Pricing models, such as the Black-Scholes model, generate the numbers to help traders make an informed decision on market change. The numbers generated associate with Greek letters and vary among options because of the different strike prices, days to expiration, and volatility. You can view the Greeks on your brokerage account, which generally display when you pull up the options chain for the underlying stock. Reading and understanding the Greeks takes practice, but it's worth the effort. Knowing how to read the Greeks will guide you in selecting options based on your risk level. However, the Greeks are by no means a crystal ball that can foresee and pinpoint stock prices for you.
Understanding the Greeks
There are five Greeks used for options trading: Delta, Theta, Gamma, Vega, and Rho.
The Delta: The Defensive Line
Delta is the rate of change for an option price for every point that the underlying stock moves. If you buy a call option, it will have a positive Delta with an inclination for moving up. If you buy a put option, it will have a negative Delta with an inclination for moving down. Delta is measured as 0 to 1.00 or 0 to 100 percent. However, the Delta can change depending on the underlying stock price and the Gamma. For example, the underlying stock price is at 125.62 with a Delta of 0.6 or 60%. If the stock moves 1 point, the option price will move 0.6. If the stock moves 5 points, the option price will move 3 points. Additionally, the higher your Delta, the higher chance of your option being in the money (ITM) at expiration. Ultimately, your Delta offers you protection so as long as you buy calls or puts that are ITM.
The Theta: The Time Thief
Theta is sometimes called time decay because it measures the rate of change of an option’s time value. An option's value consists of time and intrinsic value. Depending on whether an option is bought ITM or OTM, will decide an option’s intrinsic value and time value. Theta is often annotated as a negative number because time value decreases every day from the option’s theoretical value. Generally, around 30 days to expiration the time value of the option will exponentially decrease, which results in a worthless option. For example, if the underlying stock has a theoretical value of 5.0 with a Theta of -0.02, then the theoretical value will be at 4.8 the next day.
The Gamma: The Game Changer
The Gamma changes the Delta, which could significantly increase your profits or decimate them. As an option moves closer to expiration, the Gamma increases resulting in a higher Delta. The high Gamma can create big swings in price movement, and if not monitored closely, a huge loss could occur. For example, if the underlying stock has a Delta of 0.6 and it moves to 0.65, the Gamma is 0.05.
The Vega: The Volatility Factor (AKA Kappa)
The Vega measures the change in theoretical value for every one percent change in implied volatility. For example, if a stock has a Vega of 0.20 and a theoretical price of 2.8 at 15 percent, then the theoretical price would increase to 3.0 at 16 percent volatility. Volatility causes the options price to change, which impacts your trading strategy whether you’re buying or selling options.
The Rho: Relative to Interest Rates
The Rho measures the change in theoretical value with a change in interest rates. Rho is the least important out of all the Greeks because it's not particularly important when used to generate a theoretical value. When generating the current value of an option in a pricing model, the interest rate box is often ignored.
Applying the Greeks
There are many options trading strategies to choose from; however, you only need a handful in your playbook to be successful. Here are two of my favorite strategies that focuses on using Delta and Theta to your advantage.
1. Deep in the Money (DITM) Options
The purpose of buying DITM options is to have a high Delta. The price of the option will cost more, but you’re also purchasing protection because of the intrinsic value of the option. DITM options have a higher chance of remaining ITM and will increase in lockstep with the underlying stock as it moves.
2. Credit Spreads
This strategy is my favorite and most executed trade. For credit spreads, you’re using Theta to your advantage. Usually, Theta works against you when you buy an option because it will eventually expire and become worthless if it remains OTM. However, by executing a credit spread, you’re simultaneously buying and selling a put or call that is OTM and therefore netting a premium immediately. Once the spread expires worthless, you get to keep the full premium.
Understanding option Greeks is critical when selecting your trade. Once you master the Greeks, you will be able to better choose strategies and quickly adjust to market conditions. There are several strategies to choose from, but the DITM and credit spread strategies are the basic strategies that will develop your ability to understand the Greeks. The Greeks are not the be-all and end-all of options trading, rather, they are simply guidelines that aid traders in making smart trades.
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