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Sunday September 07, 2008 |
Understanding
Price - The Option Greeks
Okay,
we now know all of the option basics, some simple strategies and
the major factors that influence option premium prices -- that was
the easy stuff! Now
it is time to roll-up our sleeves and tackle the tougher concepts. Earlier we promised these lessons would not "bake your
noodle" so we will attempt to keep it very light with some
examples and loads of plain talk.
Once
you get past the very basic strategies, inevitably you will begin
to hear professional traders talk about the option Greeks. Named after letters in the Greek alphabet, the option Greeks
are the cornerstones of the more complex option strategies because
they tells us how variable factors will effect the price of an
option contract.
In
a nutshell, the option Greeks tells us what effect time,
volatility and changes in the price of the underlying security
will have on an option contract. If you are going to develop
strategies with many different strike prices and calendar months
you will need a thorough understanding of the Greeks.
All
of this probably sounds very technical but we swear it's very
simple. Let's begin
with the easiest of the Greeks; delta.
Delta
Delta
is the percentage an option premium will move up or down as the
underlying security moves price changes. Consider this example:
Cisco
Systems is currently trading at $94. Ben thinks Cisco stock is ready to move much higher so he
calls his broker to buy a Cisco November 100 call for a premium of
$1 per share. Ben's
broker tells him that option has a positive Delta of 25 percent
and that means for each $1 Cisco stocks increases in price he will
gain just 25 cents. By
contrast a $1 decline in Cisco shares will lead to a loss of 25
cents. Ben doesn't
like those odds so he asks the broker to recommend another option
contract. After
several moments the broker suggests that he buy the Cisco Systems
November 95 call currently trading at a premium of $2 per
contract. The broker
determines the positive Delta for this option is 75 percent, thus
a $1 rise in Cisco stock should lead to a 75 cents increase in the
option.
There
are many important nuggets of information embedded in the above
example. First, call
options have a positive Delta because they rise as the price of
the underlying security rises. By contrast, put options have negative
Deltas because they
rise in price as the price of the underlying security falls. Second,
Delta will rise as an option gets closer to the
money. This makes
good sense, if the option is in-the-money it should move in
lockstep with the underlying security. Third, because the market sets
Delta rates, Delta is fairly
good approximation of the probability an option will finish in the
money. In our example the market likes the odds of finishing in-the-money much better for the Cisco November 95 call versus the Cisco
November 100 call.
There
is one final thing we should say about Delta. When positions are combined
Delta is additive. By adding the Deltas of the options used in your strategy it
becomes easy to determine what effect a rise or decline will have
on the profitability of the strategy.
Gamma
Gamma
is the amount Delta will change as the option contract price
changes. You are
probably thinking it would have been much simpler if Delta
remained constant through the life of an option contract – that
is wishful thinking.
We
have already stated that Delta rises and falls as an option moves
toward or away from the strike price. For complex strategies it is often very useful to know how
Delta will change as the price of the option contract increases or
declines. Let's
return to our previous example.
Ben
was thinking about buying Cisco Systems calls. Previously his broker advised that he buy the Cisco
November 95 calls over the Cisco November 100 calls based on a
more favorable Delta. His
broker could have also told Ben that Gamma for the Cisco November
95 call is 23. This
means that a $1 rise in the option premium would lead to a 23 cent
rise in Delta. This
makes good sense because if Cisco rallied $1 to $95 the Cisco
November 95 calls would be at-the-money and should rally in
lockstep with Cisco common stock.
Why
is Gamma important? As
we will see in future option strategies, it is very important to
know what changes can be expected for Delta if the price of the
option contract changes.
Vega
For
many of the more complex option strategies implied volatility is
vital. Indeed, there
are many strategies based entirely upon harnessing a surge or
sharp decline in implied volatility.
Vega
is the amount in dollar terms an option premium will rise or fall
based on a one percent move in implied volatility.
Let's
return to our previous example. Ben's broker is still crunching numbers and now tells him
that the Vega for the Cisco November 95 call is 0.25. This means that the option premium will increase 25 cents
for a one- percent increases in implied volatility.
Theta
Theta is the amount an option premium will lose with the passage of one
day. All options that are bought will experience time decay, and
hence will have negative Thetas. If the Cisco November 95 calls
from our example above had a Theta of –0.02 the premium would
decrease by 2 cents in one day.
Because
time decay accelerates as option expiration approaches, it would
be normal to expect Thetas to change significantly during that
time frame.
When
using Theta we should keep in mind that options writers (sellers)
have a positive Theta since if all things stay the equal, the
probability increases that the seller will keep the option
premium.
volatility
basic
strategies
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The Option Greeks
