March 7, 2019

Option Greeks

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Options contracts don't change in value dollar for dollar with the change in stock prices. So how do you know how much an option will change in value? It's up to the Greeks!

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What Are Options Greeks?

When you buy or sell an option, you have risk and reward potential. The measurement of these risks and rewards are the Greeks. It's best if you coordinate your prediction to the corresponding Greeks. This gives you a higher chance of your prediction coming true. In the end, it means you have a higher chance of profiting off your investment.

There are many Greeks positions, but the four most common are:

What Is Delta?

Delta is the "speed" of the amount an option price may move with every $1 change in the stock's price. Calls have a positive delta between 0 and 1. Puts have a negative delta between 0 and -1.

In general, if the market price of an underlying stock increases, the price of the call increases. The delta measures how much the price increases. For example, if the delta for an option is 0.5, the option's value will increase $0.50 for every $1 the stock price increases.

Conversely, if the stock price decreased $1, the value of the call would decrease $0.50.

The value of a put works in the opposite direction. If the stock's price increases, the value of the put decreases.

A put gives you the right to sell a stock at the strike price. If the stock's price increases, your put becomes less valuable. Using the same delta of 0.5, for every $1 increase in the stock's price, the put's value decreases $0.50.

An at-the-money call or put generally has a delta of .50. The option has a 50/50 chance of expiring in or out-of-the-money.

In-the-money calls close to expiration often have a delta closer to 1. The probability the option will expire in-the-money is high.

Out-of-the-money calls close to expiration have a delta closer to 0. They have a slim chance of reacting enough to a market change, bringing it in-the-money.

Here's an example:
You buy a call option on ABC stock with a strike price of $40. If the price rises above $40 at expiration, your call ends in-the-money. You buy the stock for $40 and gain the profit of selling it at the higher market price.

Let's say the call has a 90-day expiration and the current market price is $40. You paid a $3 premium for the option. You have an at-the-money option. If the stock didn't move, your contract would expire worthless. Because it's an at-the-money option, the delta is .50.

If the stock increased in price to $41 before expiration, the value of the option contract would likely rise to $3.50. That's representative of the .50 delta.

Now let's say the stock rose again to $42. It has a higher probability of expiring in-the-money because it's further away from $40. This increases the delta. It may increase to as much as 0.65. This would mean that your option contract would be worth $3.50 + 0$0.65 = $4.15.

What this means is if you wanted to close out your position and sell the call, you could potentially sell it for $4.15. This would mean a $115 profit for closing out the position. You wouldn't buy or sell any stock.

What Is Gamma?

Delta is the speed at which the option price changes compared to the stock price. Gamma is the rate at which it changes. In other words, it's the acceleration of the change.

In general, at-the-money options near expiration respond the most to a stock's price change. Gamma is at its highest when an option is at-the-money. It begins to lose value the deeper in-the-money or out-of-the-money an option becomes.

Here's an example:
Let's say the market price of ABC stock is $35. You buy a $38 call for a $2 premium that expires in 2 months. The delta on the call is currently 0.3. The gamma is 0.10 (or 10%). If the market price of ABC stock increased to $36, the delta would increase 10%, or 0.4. This would make the value of the option increase to $2.40.

What Is Theta?

Theta is the time decay on the option. This is the time the option has to change before expiration. Theta is always negative because you lose time value with every day that passes. All bought options (long options) have zero time value at expiration.

At-the-money options have the greatest loss when it comes to theta. At-the-money options have no intrinsic value (they'll expire worthless). They are mostly time value. The more time value you have built into a premium, the more you have to lose.

What Is Vega?

Vega is the amount call and put option prices change based on a one point change in implied volatility.

Implied volatility predicts how much a stock may change over the course of a year. A stock with a 20% IV is predicted to change 20% over the next year.

The more volatile a stock, the more the corresponding option will be worth. If implied volatility increases, the option's value will climb.

Typically, the more time left in the contract, the more time value the contract has. Implied volatility directly affects time value, so the more time the contract has, the higher the Vega.

Here's an Example:
A $30 call with a 30-day expiration might have a Vega of 0.02. This means that if the implied volatility for the stock goes up 1 point, the value of the option increase $0.02.

On the other hand, a $30 call with a 6-month expiration might have a Vega of 0.2. This means if the implied volatility for the stock goes up 1 point, the value of the option increases $0.20.

The Bottom Line

You don't have to figure in the options Greeks to successfully trade options. In fact, you won't find these figures in the readily available options tables. Some options brokers do offer access to the software to determine the values, though.

If you are a beginner, focus on puts and calls and not on the Greeks. If you want to get more involved, though, using these predictors could help you solidify your investments.

More from CreditDonkey:

How to Trade Options

Trading Options

Options Trading Mistakes


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