The Greeks, Continued

In my last article, we traveled to the Greeks and stopped at Port # 1, which was known as Delta. Delta is the most popular and most widely understood of the Greeks.

The other Greeks are the subject of today's article. We will go thru a brief outline of Gamma, Vega, Theta and Rho. This outline is not meant to provide more than a cursory understanding of these concepts. As time allows, we may address one or more of the Greeks in depth in later articles.

Brief review here, delta represents the amount an option price will change with the movement of stock price. Delta is directional, meaning that trades with a positive delta are bullish, while trades with a negative delta are bearish. Delta also provides a rough estimate of the likelihood that the option will expire in-the-money.

Gamma provides us with the measure of how delta changes as the stock moves. When a stock moves, delta will not only indicate the price change of the option, but the value of delta will change as well. As the stock moves in the direction of the trade, the delta grows, approaching its maximum of 1. When an option is at-the-money, the gamma is largest. This translates into the delta moving biggest on at-the-money options. Gamma is also sensitive to the time remaining until expiration. The closer we get to expiration, the bigger the gamma value becomes. This translates into the delta, and therefore, the option price changing more dramatically closer to expiration.

Vega is the only Greek that is not actually represented by a figure from the Greek alphabet. The reason it was chosen as a symbol here is that it starts with the letter V and sounds a little bit like Greek. The letter 'V' is significant because Vega represents the change in an option price when implied volatility moves. V = Volatility, how high brow and snazzy is that? Implied volatility is a direct factor in an options price. When it moves up or down, the option premium goes with it. Vega tells us how much a one percentage point move in IV will change the price of the option. When we buy options, we have a positive Vega number, which correlates to an increase in the option as IV goes up…or a decrease in the option price as IV drops. Selling options will generate a negative Vega number, with the opposite impact.

Implied volatility, incidentally, is a very complex and interesting subject in its own right. Perhaps we can pursue that in a later article.

The passage of time is one of the constants of life. We can't stop it, slow it down, or reverse it. Theta is the Greek that measures the impact of time passing on our option price. Each day that goes by decays the price of our option by the Theta amount. When we buy options, this Theta decay is working against us. When we sell options to open our positions, Theta is positive and the time decay is working for us. We are making money from the simple passage of time. Time decay is exponential in nature, meaning that as we get closer to expiration, the amount of premium decayed grows faster and faster. In the last 30 days of an option's life, this time decay becomes more and more extreme…at the end, there is no time value left to decay. The value of Theta will increase at a dramatic rate in the last weeks of expiration, becoming extreme in the last week.

Rho is the least known and probably least important of the Greeks when it comes to our individual trading. Rho represents the change in an option price in relation to changes in interest rates. The piece of the pie that Rho accounts for is very small; small enough that we don't really worry about it. Interest rates don’t generally change in big ways at a fast rate, so the impact from these changes on our trade are very minimal. The value of Rho tells us how much our option price will change with a 1 percentage point change in rates.

Now let's take a look at an example or two of how the various Greeks affect an option price:

CSCO Nov 23 call trading at $1.00 per contract. The Greeks are: delta = .50 ($50.00 per share), gamma = .15 ($15.00 per share), vega = .0356 ($3.56 per share), theta = .0099 ($0.99 per share).

So to buy one of the above contracts would cost us $100.00. Some possible moves and their outcomes follow. If you follow along, you'll see the Greeks in action!

CSCO moves up by $1 per share by close of market today, implied volatility remains the same. The resulting values for the position would be:

Position value = $149.01
Price of the option moved up by the delta of .50 per share or total of $50.00. The time decay for the passage of today reduced the price of the position by the theta amount of .0099 or $0.99 when multiplied by 100 shares per contract. The new delta would become .65 or $65.00. This is shown by the gamma of .15 added to the original delta.

Another example:
FSLR Oct 170 call trading at $2.45 per contract. If we sold one contract the Greeks would be: delta = -$23, gamma = -$1.5, vega = -$11.20, theta = $14. Notice the positive theta and negative delta, gamma and vega. Delta is negative due to selling calls (bearish). The gamma and vega are negative and the theta positive simply because we sold an option.

Selling one contract would generate a credit of $245.00. Let's see how this one might change…

FSLR goes up by $1.00 and implied volatility goes down by 1% point. Two days pass. The resulting value for this position would be:

Position value = $228.80. Here is how it came to be: stock move up $1 results in an increase to $268 (245 + 23 deltas = 268), implied volatility move down results in a decrease to $256.80 (268 – 11.20 vega = 256.80), two days of time passing results in a decrease to $228.80 (256.80 - 28 (14 per day x 2) = 228.80). This $228.80 translates into a profit of $16.20 for the position.

I hope these illustrations help demonstrate how to analyze a position from the perspective of the Greeks. As you can surely imagine…the math can become extremely complicated when we have real market movements going on all the time. Stock price, implied volatility and time are in flux all the time. No wonder the people who came up with the pricing model and these Greek concepts won the Nobel Prize for their efforts.

So there we have it. The Greeks are outlined for us. Remember that this is just a high level look at things. There is much we could explore on each of the Greeks, and certain trading strategies and approaches take advantage of the Greeks in varying ways. The bottom line is that we need to be aware of the potential impact of these things on our trades, and address them in appropriate ways according to our trading style, strategy choices, risk tolerance, etc. Happy trading!

You can learn more about different types of option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

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