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Kim

Options Greeks: Theta, Delta, Vega, Gamma

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Hi all,

  1. i have searched vomma in SO.com and found just 1 answer. 
  2. Why don't we use the higher order greeks.
  3. Is it too difficult?
  4. Gamma is a second order greek and is sometimes used, but the others like vomma (first derivative of vega)
  5. To learn more about 2nd order greeks what do you suggest (sites, ...).
  6. Do i have to study in detail the Black-Scholes equation?

There is a site SJOptions.com where the higher greeks are succesfully used, they say "we implement 2nd Order Greeks to

produce better results" http://sjoptions.com/portfolios/what-makes-us-unique/

Pirol

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3 hours ago, Pirol said:

Hi all,

  1. i have searched vomma in SO.com and found just 1 answer. 
  2. Why don't we use the higher order greeks.
  3. Is it too difficult?
  4. Gamma is a second order greek and is sometimes used, but the others like vomma (first derivative of vega)
  5. To learn more about 2nd order greeks what do you suggest (sites, ...).
  6. Do i have to study in detail the Black-Scholes equation?

There is a site SJOptions.com where the higher greeks are succesfully used, they say "we implement 2nd Order Greeks to

produce better results" http://sjoptions.com/portfolios/what-makes-us-unique/

Pirol

Not an expert in second order greeks, but I think vomma would matter more if you trade naked strangles/straddles and concerned about the margin expansion. Since we only trade defined risk, explosions in vega/vomma won't change our margin. That being said, we deal with the standard 4 greeks a lot, especially with the earnings trades.   

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      This leads me to believe the market may be stuck in no-man’s land.

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      In this article, I will try to help you understand Options Greeks and use them to your advantage.
       
      The Basics
       

       
      First, a quick reminder for those less familiar with the Options Greeks.
       
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      Example
       
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      Buy to open 4 ORCL July 17 2015 44 put
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      Price: $2.66 debit
       

       
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      Make them Work For You
       
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    • By Michael C. Thomsett
      And of course, a lower delta reveals a less responsive likely reaction among option contracts, to movement in the underlying.
       
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      The Other Greeks
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      Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.

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    • By Kim
      In other words, an option premium that is not intrinsic value will decline at an increasing rate as expiration nears. 

      The Theta is one of the most important Options Greeks.
       
      Negative theta vs. positive theta
       
      Theta values are negative in long option positions and positive in short option positions.  Initially, out of the money options have a faster rate of theta decay than at the money options, but as expiration nears, the rate of theta option time decay for OTM options slows and the ATM options begin to experience theta decay at a faster rate. This is a function of theta being a much smaller component of an OTM option's price, the closer the option is to expiring.
       
      Theta is often called a "silent killer" of option buyers. Buyers, by definition, have only limited risk in their strategies together with the potential for unlimited gains. While this might look good on paper, in practice it often turns out to be death by a thousand cuts.
       
      In other words, it is true you can only lose what you pay for an option. It is also true that there is no limit to how many times you can lose. And as any lottery player knows well, a little money spent each week can add up after not hitting the jackpot for a long time. For option buyers, therefore, the pain of slowly eroding your trading capital sours the experience.
       
      When buying options, you can reduce the risk of negative theta by buying options with longer expiration. The tradeoff is smaller positive gamma, which means that the gains will be smaller if the stock moves.
       
      Option sellers use theta to their advantage, collecting time decay every day. The same is true of credit spreads, which are really selling strategies. Calendar spreads involve buying a longer-dated option and selling a nearer-dated option, taking advantage of the fact that options expire faster as they approach expiration.
       
       You can see the accelerated curve of option time decay in the following graph:
       

       
      As a general rule of thumb, option sellers want the underlying to stay stable, while option buyers want it to move.
       
       List of positive theta options strategies
      Short Call Short Put Short Straddle Short Strangle Covered Call Write Covered Put Write Long Calendar Spread Vertical Credit Spread Iron Condor Butterfly Spread  List of negative theta options strategies
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      Watch this video:
       
       
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    • By Kim
      In this article, I would like to show how the gamma of the trade is impacted by the time to expiration.

      For those of you less familiar with the Options Greeks:
       
      The option's gamma is a measure of the rate of change of its delta. The gamma of an option is expressed as a percentage and reflects the change in the delta in response to a one point movement of the underlying stock price.
       
      This might sound complicated, but in simple terms, the gamma is the option's sensitivity to changes in the underlying price. In other words, the higher the gamma, the more sensitive the options price is to the changes in the underlying price.
       
      When you buy options, the trade has a positive gamma - the gamma is your friend. When you sell options, the trade has a negative gamma - the gamma is your enemy. Since Iron Condor is an options selling strategy, the trade has a negative gamma. The closer we are to expiration, the higher is the gamma.
       
      Lets demonstrate how big move in the underlying price can impact the trade, using two RUT trades opened on Friday March 21, 2014. RUT was trading at 1205.
       
      The first trade was opened using weekly options expiring the next week:
      Sell March 28 1230 call Buy March 28 1240 call Sell March 28 1160 put Buy March 28 1150 put  
      This is the risk profile of the trade:
       

       
      As we can see, the profit potential of the trade is 14%. Not bad for one week of holding.
       
      The second trade was opened using the monthly options expiring in May:
       
      Sell May 16 1290 call Buy May 16 1300 call Sell May 16 1080 put Buy May 16 1070 put  
      This is the risk profile of the trade:
       

       
      The profit potential of that trade is 23% in 56 days.
       
      And now let me ask you a question:
       
      What is better: 14% in 7 days or 23% in 56 days?
       
      The answer is pretty obvious, isn't it? If you make 14% in 7 days and can repeat it week after week, you will make much more than 23% in 56 days, right? Well, the big question is: CAN you repeat it week after week?
       
      Lets see how those two trades performed few days later.
       
      This is the risk profile of the first trade on Wednesday next week:
       

       
      RUT moved 50 points and our weekly trade is down 45%. Ouch..
       
      The second trade performed much better:
       

       
      It is actually down only 1%.
       
      The lesson from those two trades:
       
      Going with close expiration will give you larger theta per day. But there is a catch. Less time to expiration equals larger negative gamma. That means that a sharp move of the underlying will cause much larger loss. So if the underlying doesn't move, then theta will kick off and you will just earn money with every passing day. But if it does move, the loss will become very large very quickly. Another disadvantage of close expiration is that in order to get decent credit, you will have to choose strikes much closer to the underlying.
       
      As we know, there are no free lunches in the stock market. Everything comes with a price. When the markets don't move, trading close expiration might seem like a genius move. The markets will look like an ATM machine for few weeks or even months. But when a big move comes, it will wipe out months of gains. If the markets gap, there is nothing you can do to prevent a large loss.
       
      Does it mean you should not trade weekly options? Not at all. They can still bring nice gains and diversification to your options portfolio. But you should treat them as speculative trades, and allocate the funds accordingly. Many options "gurus" describe those weekly trades as "conservative" strategy. Nothing can be further from the truth.
       
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    • By GavinMcMaster
      Most serious traders probably have a pretty good grasp of delta.

      However, there is one metric related to delta that I use religiously in my trading and that is Dollar Delta.

      What is Dollar Delta?

      Dollar Delta is quite simply the position delta x the underlying price.
       
      We know that delta gives us the share equivalency ratio, so if we own a long call with delta 0.40 it is equivalent to being long 40 shares of the underlying.
       
      Let’s assume the stock is trading at $100. The delta dollars figure would be 40 x $100 = $4,000.
       
      This tells us that the option position is equivalent to having $4,000 invested in the stock.
       
      The delta dollars figure is going to depend a lot on the price of the stock. Let’s say that instead of the stock trading at $100, it was trading at $500. Our delta dollars figure in this example would be 40 x $500 = $20,000.
       
      Perhaps now you can understand why it’s important to look at the delta dollars number and not just the delta.
       
      Why is it important

      Dollar Delta tells us our overall directional exposure in the market.
       
      If our account size is $50,000 and out delta is 100, that doesn’t really tell us much.
       
      But if our delta dollars exposure is $200,000 then we know that it is too high for our account size.
       
      Personally, I like to set a rule that I don’t let my delta dollar exposure get above 150% of my account size. More conservative traders might like to set that rule at 100%, whereas more aggressive traders might set it at 200%.
       
      It’s personal preference, but the first step as a delta neutral trader is to start paying attention to delta dollars and then develop rules around this metric.
       
      I also have rules regarding the delta dollar exposure for each trade and strategy.
       
      Practical example
       
      For an iron condor, I usually set a 200% rule for Dollar Delta.
       
      Assume you have an iron condor on RUT that is risking $20,000. If the Delta Dollars figure gets above plus or minus $40,000 you might want to think about adjusting and getting back closer to neutral.


       
      Further learning
       
      If you’re interested in learning more about delta and delta dollars I’ll be running a free webinar on Tuesday April 11th at 8pm New York time.

       
      You can register here.
       
      About the author: Gavin has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. He likes to focus on short volatility strategies. Gavin has written 5 books on options trading, 3 of which were bestsellers. You can read more from Gavin at Options Trading IQ.
    • By Kim
      Introduction
       
      In November of 2012, CBOE and C2 issued Information Circulars IC12-093 and IC12-015 announcing the expansion of the number of Weeklys that can be listed for certain securities. CBOE and C2 may now list up to five consecutive Weeklys in a class provided that an expiration does not coincide with one that already exists.
       
      According to CBOE, "Weeklys were established to provide expiration opportunities every week, affording investors the ability to implement more targeted buying, selling and spreading strategies. Specifically, Weeklys may help investors to more efficiently take advantage of major market events, such as earnings, government reports and Fed announcements."
       
      Not every stock or index has weekly options. For those that do, it basically means that every Friday is an expiration Friday. That opens tremendous new opportunities but also introduces new risks which can be much higher than "traditional" monthly options. 
       
      Basically, just about any strategy you do with the longer dated options, you can do with weekly options, except now you can do it four times each month.

      Let's see for example how you could trade SPY using weekly or monthly options. 
       
      Are they cheap? Lets buy them

      SPY is traded around $218 last Friday Aug. 19, 2016. Looking at ATM (At The Money) options, we can see that Sep. 16 (monthly) calls can be purchased at $2.20. That would require the stock to close above $220.20 by Sep. 16 just to break even. However, the weekly options (expiring on August 26, 2016) can be purchased at $1.08. This is 50% cheaper and requires much smaller move. 

      However, there is a catch. First, you give yourself much less time for your thesis to work out. Second and more importantly, the weekly options are much more exposed to the time decay (the negative theta). 

      The theta is a measurement of the option's time decay. The theta measures the rate at which options lose their value, specifically the time value, as the expiration draws nearer. Generally expressed as a negative number, the theta of an option reflects the amount by which the option's value will decrease every day. When you buy options, the theta is your enemy. When you sell them, the theta is your friend. 

      For the monthly 218 calls, the negative theta is -$4.00. That means that the calls will lose ~1.8% of their value every day all other factors equal. For the weekly calls, the negative theta is a whopping -$7.70 or 7.1% per day. And that number will accelerate as we get closer to the expiration day. You better be right, and you better be right quickly. 

      Buying is too risky? Maybe selling is better? 

      If this is the case you might say - why not to take the other side of the trade? Why not to use the accelerating theta and sell those options? Or maybe be less risky and sell a credit spread? A credit spread is when you sell an option and buy another option which is further from the underlying price to hedge the risk. 

      Many options "gurus" ride the wave of the weekly options trading and describe selling of weekly options as a cash machine. They say that "It brings money into my clients account weekly. Every Sunday my clients access their accounts and see + + +.” They advise selling weekly credit spreads and present it as a "a safe option strategy because we’re combining an option purchase with an option sale resulting with a credit into your account". 

      This short term option trading strategy can work very well... until it doesn't.

      Imagine for example someone selling a 206/205 put credit credit spread on Thursday June 23, 2016 with SPY around $210.80. That seems like a pretty safe trade, isn't it? After all, we have just one day, what could possibly go wrong? The options will probably expire worthless and the clients will see more cash in their account by Sunday. Well, after the market close, news about Brexit took traders by surprise. The next day SPY opened below $204 and the credit spread has lost almost 100%. So much for the "safe strategy". 
      Of course this example of weekly options trading risks is a bit extreme, but you get the idea. Those are very aggressive trades that can go against you very quickly.
       
      Be Aware of the Negative Gamma

      So what is the biggest problem with selling the weekly options? The answer is the negative gamma. 
       

      Condor Evolution. Source: http://tylerstrading.blogspot.ca/2010/09/condor-evolution.html

      The gamma is a measure of the rate of change of its delta. The gamma of an option is expressed as a percentage and reflects the change in the delta in response to a one point movement of the underlying stock price. When you buy options, the gamma is your friend. When you sell them, the gamma is your enemy. 

      When you are short weekly options (or any options which expire in a short period of time), you have a large negative gamma. Any sharp move in the underlying will cause significant losses, and there is nothing you can do about it. 
       
      Here are some mistakes that people make when trading Iron Condors and/or credit spreads:
      Opening the trade too close to expiration. There is nothing wrong with trading weekly Iron Condors - as long as you understand the risks and handle those trades as semi-speculative trades with very small allocation. Holding the trade till expiration. The gamma risk is just too high. Allocating too much capital to Iron Condors. Trying to leg in to the trade by timing the market. It might work for some time, but if the market goes against you, the loss can be brutal and there is no another side of the condor to offset the loss.
      The Bottom Line 

      So is the conclusion that you should not trade the weekly options? Not necessarily. Short term option trading can be a good addition to a diversified options portfolio - as long as you are aware of the risks and allocate only small portion of the account to those trades.
      Just remember that those options are aggressive enough to create quick profits or quick losses, depending on how you use them. 

      Related articles:
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