Options Greeks: Theta, Delta, Vega, Gamma
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By Chris Young
What Are Options Greeks?
Financial derivatives can be volatile and sensitive to factors such as changes in the pricing of the underlying asset. Each character denotes the of sensitivity of an option’s price to the change in some attribute of the underlying asset, such stock price and volatility.
These attributes are components of risk that a trader needs to control if he/she is to manage the risk of their portfolio.
The Greek characters are easy to calculate and are a popular tool amongst derivatives traders, especially since the letters are very useful in portfolio hedging, which enables the investors to protect their investments from adverse changes within the market.
Not only that, the Greek alphabets allow an investor to determine how much risk their portfolio is facing and from which area is the risk the greatest.
The 5 related Greek Characters are: Delta, Gamma, Vega, Theta and Rho. (Vega is a bit of cheat: there is no such greek letter. Often epsilon is used instead).
We will look at each in turn and, in particular, how we will use them to control our trades’ risk.
Options Greeks: Delta
What Is Delta?
Delta measures option price sensitivity to changes in the price of the underlying asset.
Option Delta is perhaps one of the most vital measurement methods of all, as it can investigate the level of sensitivity that an option’s price will move, if there is a change in the underlying stock price.
(As with all the other options Greeks, we assume that all other of the options parameters don’t change when looking at delta).
If the option has a delta of 1.5, it means that there will be a price movement of 1.5 cents for every cent the underlying stock moves.
Therefore, this shows that an option with a high delta reading will increase or decrease in value more considering the direction of the price change.
As compared to another option with a low delta which will not move as much from changes in the price of the underlying stock.
Delta signs for long and short options:
How is Delta Used?
The importance of the information that the Greek Delta can provide is indispensable. This is especially the case where, in the real world, investors rarely hold options until maturity.
Knowing how much profit that can be reaped or the potential losses that will be incurred from a single movement in price will be one factor an investor uses to determine whether they should still hold the option or sell it.
Complication
Unfortunately there is a complication with delta: it also moves as the price moves. So that 1.5 delta option may move 1.5 cents higher for 1 cent move in the underlying, but then the delta may have changed to 1.6.
Hence any further increase in share price will cause an even bigger increase in the price of an option. This effect is an example of positive gamma – to be explained in our next lesson – and can be thought of as the price ‘accelerating’ higher.
Click here for more on the greek: options delta.
(NB We have recently published a post on the related concept of Position Delta).
Options Greeks: Gamma
What is Gamma?
We saw above that the Greeks are an important measure of risk to used by options traders to assess the impact in changes of certain variables on the price of an option.
In particular we looked at one of these, delta: the sensitivity of option prices to changes in the price of the underlying security.
Unfortunately, again as we saw, the relationship between stock price sensitivity (delta) and the stock price is not linear.
For example if a stock moves up, call options will become even more sensitive to further changes to the stock price. This effect is called gamma. It measures the change in delta, i.e. sensitivity to stock price movements.
Positive gamma means that as a stock rises the option’s price will more sensitive to further stock changes. Negative gamma means the opposite: stock price rises cause stocks to be less sensitive.
Why should we be concerned about Gamma?
Gamma is the key enemy of many of the options strategies we use. It tends to rise as an option moves closer to expiration. Hence in the last week of an option’s life small changes in stock prices cause large, and accelerating, swings on options prices.
This is unfortunate as many of our favorite strategies – such as the iron condor or calendar spread – rely on time decay. They relay on time passing to make money.
Often a trader has to weigh up the potential profits, from time decay, of leaving a strategy on versus the increasing risk of the stock moving and wiping out those profits.
It is for this reason that most experienced options traders rarely keep a trade on until expiration. We take a particularly risk averse line: we tend to remove our standard time decay exploiting trades at least 2 weeks before expiration.
For example, look at our trade rules for putting on this calendar spread. Notice the last ‘Trade Management – Exit’ rule. We would get out of the trade within 2 weeks of expiration to avoid the gamma risk.
Such is the power of gamma that trading with positions with large gamma – expiration week trades for example – is known colloquially as ‘riding the gamma bull’. Not for the faint hearted.
Uses of Gamma
We’ve seen that Gamma is often seen as an enemy. But this is usually only relevant to those trades, admittedly the most popular, that relay on time decay to profit.
Some trades, however, take the opposite course: they take advantage of the accelerating price sensitivity from gamma to make money from expected changes in stock prices.
One good example of this is the simultaneous purchase of an at-the-money put and call, called a long straddle, Let’s say a stock was $650.
We expect significant stock movement, from a product launch for example, over the short term and so buy a $650 call and a $650 put.
Such a purchase has strong gamma. Stock movement not only increases the price of the spread, these price changes are increased the more the stock changes, either way.
(Don’t worry too much about the mechanics of this: we will have a more detailed course on straddles later).
The catch, and key risk, is time, the opposite of the trades mentioned above.
Time decay works against us here: if there is no stock movement then the spread will gradually lose money. Indeed the spread loses value every day – all things being equal – and so there is an amount of stock movement required each day just to break even.
The trader has to be sure that the stock move, and move quickly, for the trade to be profitable.
(This example is taken from a real life trade here. We used an APPL straddle to exploit expected movement from the iphone5 launch. Ignore, for now the discussion on increases in implied volatility: this will be part of the Vega lesson).
Gamma vs. time:
Gamma scalping
One advanced use of gamma is ‘gamma scalping’, something you may hear about from experienced traders.
It’s pretty complex – it takes advantage of the ‘boost’ in option price changes from excessive stock movement whilst managing delta risk (I said it was complex) – and I may include it in a later advanced post, but I suggest that most of you don’t worry about this strategy at present.
Click here for more on the Greek: options gamma.
Options Greeks: Vega
What Is Vega?
Vega is a measure of an option’s sensitivity to changes to implied volatility (IV). As we’ve seen earlier, implied volatility is the market’s estimate of the volatility (measured by standard deviation) in the future.
It’s an input into the standard options pricing models and hence any change in this expectation, in other words any change in implied volatility, will affect the price of options.
How does it affect the price?
In general bought options, either calls or puts, increase in value as IV increases. This makes sense: an option seller would want to be compensated more for the increased future risk, as priced by the market, of the option moving in the money.
Stocks expected to be more volatile, and hence have higher IVs, have higher options prices, everything else being equal.
Short options decrease in value, the higher IV is for the same (but opposite) reasons. Things get interesting once options are combined in a spread. Some combinations such as a Calendar Spread increase in value as IV increases. Others, such as the Iron Condor, decrease.
Uses of Vega
Many options strategies rely on picking the way volatility moves. For example should be believe that we are to have a market correction we would, of course, be interested in the effect of stock price falls on our options positions.
But we’d be also interested in what the associated increase in IV would have on the position. There are some trades that rely solely on Vega: volatility trades.
IV tends to be mean reverting and so any short term deviation could produce a correcting change in the near future.
For example many traders look for the difference between historical volatility – how volatile the market is right now – to implied volatility – a future volatility prediction.
There is some evidence to say if these two indicators diverge than they will soon get closer together. This can be traded if you know the volatility effect of IV on an options trade. In other words, Vega.
Click here for more on the Greek: options vega.
Options Greeks: Theta
What Is Theta?
Theta is a measure of the time decay of an options, or option spread. As we have seen elsewhere in the courses, options are a decaying asset: they reduce in value over time.
All things being equal an option is worth more the longer it has to go until expiry; an option with 60 days of time left to expiry will be worth more than one with only 30 days.
The expected drop of an option value, again all things being equal, in the next 1 day is Theta (expressed as a negative).
For example, at the time of writing, you can buy an ATM June 13 445 APPL call with 23 days until expiration for about $12. It has a Theta of -0.24, meaning it will lose $0.24 in the next 24 hours if nothing – share price, volatility etc – changes.
Uses of Theta
Theta is the basis of many of the standard options trades we use in this course. Strategies which involve selling options – or at least there are ‘more’ sales than purchases – have positive theta (ie they rise in value over time).
If we were to sell the above AAPL call options for $12 and nothing changed, we could buy them back at $11.76, the next day for $0.24 profit. If nothing else changed of course.
This rather simplistic example shows the way to more (and much less risky) ways we can profit from theta. Take the vertical spread. Let’s say you thought Apple wasn’t going to rise in the next 23 days.
You could sell a 450 call and buy a 480 call and receive a net credit of $4.70. The 450 call has a theta of -0.24; the 480 call a theta of -0.14 and hence the net theta is -0.10. We have reduced our risk (of a significant share price increase) but are still making $0.10 a day all things being equal.
Effect of time on Theta
Theta is the effect of time on options pricing. However it too changes with time. In general theta increases as expiration nears. Another way of saying this is that the time decay accelerates closer to acceleration.
You can see this from our sold AAPL 445 call above. It will lose $0.24 between day 23 and day 22. If theta was constant it would only lose 23x$0.24=$5.52 of its value between now and expiration. But it is worth $12 – which must all be lost by day 23.
Hence Theta must increase at some stage this to happen. Here’s a graph of what happens:
Options Time Decay
Notice how the value of the option (time value) accelerates near the end of its life. This is the theta increasing.
Gamma and Theta
So why don’t you wait until the last few days to sell your options? All that nice accelerating time decay should reduce your option price quick only for to buy them back or let them expire for a quick profit. Easy.
Well, unfortunately not. We have been looking at Theta in isolation. But we know from our last course that another of the Greeks increases with time: gamma. This is the acceleration of the effect stock price has on the option price.
Increasing time decay is matched with increasing sensitivity for price changes and so any time decay could be wiped out by an adverse move in the share price.
This is a good example of the interplay between the Greeks. In general strategies that exploit theta have to contend with gamma and vice versa. We will see more interrelationships later. In the meantime though we will look at the last of the major Greeks, Rho.
Click here for more on the greek: options theta.
Options Greeks: Rho
What Is Rho?
Rho is a measure of the sensitivity of options prices to changes in interest rates. It is defined as the increase in price of an options, or options portfolio, as a result of a 1% increase in interest rates.
Relevance
Rho is often ignored by options traders as interest rates are unlikely to change (much) during the course of most options spreads. Hence changes in interest rates are usually ignored.
However there are times where more notice should be taken of Rho. Long term options, such as LEAPS, are more sensitive to changes in interest rates, ie have a higher Rho.
At the time of writing an at the money AAPL call option with 32 days to go has a Rho of 0.3 (a 1% interest rate rise would produce a small, 0.3%, increase in the options price). However a LEAP with 578 days to go has a Rho of 2.2. Hence any LEAP strategy, such as our LEAP Covered Calls, would be affected somewhat by a change in interest rates.
The other time Rho should be at least considered is, of course, when interest rates are changing. At the time of writing, for example, there is a strong possibility that the Fed will remove its QE program thus causing, amongst other things, an increase in interest rates.
Hence, all things being equal, may be see an increase in options prices over the next few months/years.
In conclusion Rho can be an important factor in certain circumstances – when interest rates are expected to change and/or we are looking at long term options – but in general Rho is a far less important Greek than Delta, Gamma, Theta and Vega.
Click here for more on the Greek: options rho.
About the Author: Chris Young has a mathematics degree and 18 years finance experience. Chris is British by background but has worked in the US and lately in Australia. His interest in options was first aroused by the ‘Trading Options’ section of the Financial Times (of London). He decided to bring this knowledge to a wider audience and founded epsilonoptions.com in 2012.
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Related articles:
Options Delta Explained: Sensitivity To Price Options Theta Explained: Price Sensitivity To Time Options Gamma Explained: Delta Sensitivity To Price Options Vega Explained: Price Sensitivity To Volatility Options Rho: Sensitivity To Interest Rates
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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.
Related articles
Options Greeks: Theta, Gamma, Delta, Vega And Rho Options Vega Explained: Price Sensitivity To Volatility Options Theta Explained: Price Sensitivity To Time Options Delta Explained: Sensitivity To Price Options Gamma Explained: Delta Sensitivity To Price The Use And The Abuse Of The Weekly Options The Risks Of Weekly Credit Spreads Should You Trade Weekly Options? Make 10% Per Week With Weeklys?
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By Mark Wolfinger
Questions:
Do options ever become so expensive that it is no longer worthwhile to pay the high asking price to buy them? We may know that a news announcement is pending, but so do other investors —and they also want to buy options. Translation: Increased demand results in a significant increase in option prices and implied volatility. How can we determine whether a point has been reached such that we have a better opportunity to earn money by switching to negative-gamma (i.e., the opposite of our traditional) strategies?
For this discussion, let’s consider premium-buying strategies are limited to market neutral strategies like buying long straddles and strangles, buying single options, and trading reverse iron condors where you buy the call and put spreads, paying a cash debit to own the position
Similarly, the premium-selling strategies are limited to market neutral strategies like selling straddles, strangles and single options. Also the traditional iron condor (sell both the call and put spreads and collect a cash credit).
Answers:
It should be intuitively obvious that there has to be some price at which it no longer pays to buy options to own positive positive gamma. [For an extreme example, I hope that you would never pay $8 for a pre-earnings, ATM straddle on a non-volatile, $20 stock.] Thus, as intelligent traders, we are limited and cannot adopt our favorite strategies every time there is an earnings announcement pending. Due diligence is required, and that includes analyzing a substantial amount of historical data so that we can estimate what may happen in the future by looking at what occurred in the past. Such data includes:
Previous post-news price gaps. We want to know the largest and smallest (based on a percentage of the stock price) and the median gaps when this specific stock announced earnings results. We do not need results from the last 20 years because stock markets change over time and more recent history is far more important. I suggest using 3 to 4 years of data (12 to 16 news announcements). Why is this information so important?
The data provides a good estimate of how much you can afford to pay for the options. There are two ways to profit.
First, exit the trade whenever there is a satisfactory profit before news is released.
When implied volatility increases by enough, your position increases in value and it may be attractive to unload the position and lock in the gains prior to the news release.
When the stock makes a big move prior to the news release, the positive-gamma position will be worth far more than you paid for it —and that may be a profit worth taking.
Second, when we do wait for the news release, the profitability of the trade depends on the size of the price gap and the cost of the options.
By looking at past data, we have a reasonable estimate for the size of any future price gap and thus, the value of our option position. Obviously this is just an estimate and the current trade may perform much better or much worse than the average. But, it is that average that dictates just how much we should pay for our option position. If the ATM straddle is worth $6 (on average) immediately after the market opens after the announcement, then we should not be willing to pay as much as $6 to buy the straddle.
The average implied volatility must be considered. If the IV averages 34 for the time slot (i.e., number of days in advance of news), in which we buy the options then we cannot expect to earn a profit when paying 40.
The cost (IV) of buying the pre-news options at a variety of times. It is important to discover a good time to buy the options (i.e., before IV has risen too far in anticipation of the pending news).
The price history for the stock, in the days leading up to the news release: How often did the stock rally/fall enough to generate a good profit without bothering to hold until the earnings news is released? If this never happens for a given stock, then the price that we can pay for a the straddle decreases because one of our profit opportunities is not present.
Results. How would various gamma-buying strategies have performed in the past? This requires examining option-pricing data as well as the stock price.
There is a lot of data that a trader may analyze.
The work produces guidelines for making trades, and we depend on those guidelines to tell us when to enter, and when to avoid, using our methods.
The second question is more difficult to answer because so much depends on the individual trader. For example, some traders will never sell straddles or strangles because risk is too high. Others understand how to manage risk for such trades (most important is choosing proper position size) and would adopt the negative-gamma strategies when the option prices are so high that it is reasonable to anticipate earning a profit by selling them.
Be careful. If you decide that paying $9 for a straddle (or paying a 34 implied volatility) is too high to buy the options that does not suggest that it is okay to sell. Selling requires a decent edge. For example, if your maximum bid for a straddle is $6 (reminder: the average post-news straddle is worth $9), I would not want to consider selling that same straddle unless I could collect $12 (or an IV of at least 40). Those numbers describe my personal guidelines and you must choose your own.
There is a lot of work to do before investing your money into option trades. Fortunately SteadyOptions does the tedious analysis and we can trade their suggestions. There is no guarantee of success. However, it is always good to trade with the probabilities on your side — and that is what you get with your SO membership.
Related articles:
Options Trading Greeks: Gamma For Speed Why You Should Not Ignore Negative Gamma
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Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Since leaving the Exchange, Mark has been giving trading seminars as well as providing individual mentoring via telephone, email and his premium Options For Rookies blog. Mark has published four options trading books. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University.
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By Kim
The Gamma is one of the most important Options Greeks.
It generally is at its peak value when the stock price is near the strike of the option and decreases as the option goes deeper into or out of the money. Options that are very deeply into or out of the money have gamma values close to 0.
Effect of volatility and time to expiration on gamma
Gamma is important because it shows us how fast our position delta will change as the market price of the underlying asset changes.
When volatility is low, the gamma of At-The-Money options is high while the gamma for deeply into or out-of-the-money options approaches 0. The reason is that when volatility is low, the time value of such options are low but it goes up dramatically as the underlying stock price approaches the strike price.
When volatility is high, gamma tends to be stable across all strike prices. This is due to the fact that when volatility is high, the time value of deeply in/out-of-the-money options are already quite substantial. Thus, the increase in the time value of these options as they go nearer the money will be less dramatic and hence the low and stable gamma.
As the time to expiration draws nearer, the gamma of At-The-Money options increases while the gamma of In-The-Money and Out-of-The-Money options decreases.
How to put gamma work for you
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. The closer we are to expiration, the higher is the gamma.
When you buy options and expect a significant and quick move, you should go with closer expiration. The options with closer expiration will gain more if the underlying moves. The tradeoff is that if the underlying doesn't move, the negative theta will start to kick off much faster.
When you sell options, you have negative gamma that will increase significantly as the options approach expiration. This is the biggest risk of selling weekly options.
Should you trade weekly options?
Selling options with closer expiration will give you higher positive theta per day but higher negative gamma. That means that a sharp move of the underlying will cause much higher 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.
Example
Lets sat you have a call with a delta of .60. If the price of the underlying security rises by $1, then the price of the call would therefore rise by $.60. If the gamma value was .10, then the delta would increase to .70. This means that another $1 rise in the price of the underlying security would result in the price of the option increasing by $.70, and the delta would also increase again in accordance with the gamma.
This highlights how moneyness affects the delta value of an options contract, because when the contract gets deeper into the money, each price movement of the underlying security has a bigger effect on the price. The gamma is also affected by moneyness, and it decreases as an in the money contract moves further into the money.
This means that as a contract gets deeper into the money, the delta continues to increase but at a slower rate. The gamma of an out of the money contract would also decrease as it moved further out of the money. Therefore, gamma is typically at its highest for options that are at the money, or very near the money.
List of gamma positive strategies
Long Call Long Put Long Straddle Long Strangle Vertical Debit Spread
List of gamma negative strategies
Short Call Short Put Short Straddle Short Strangle Vertical Credit Spread Covered Call Write Covered Put Write Iron Condor Butterfly Long Calendar Spread
Summary
Gamma measures the rate of change for delta with respect to the underlying asset's price. All long options have positive gamma and all short options have negative gamma. The gamma of a position tells us how much a $1.00 move in the underlying will change an option’s delta. We never hold our trades till expiration to avoid increased gamma risk.
Watch the video:
Related articles:
The Options Greeks: Is It Greek To You? Options Trading Greeks: Theta For Time Decay Options Trading Greeks: Delta For Direction Options Trading Greeks: Vega For Volatility Why You Should Not Ignore Negative Gamma Short Gamma Vs. Long Gamma
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By Kim
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.
The Delta is the rate of change of the price of the option with respect to its underlying price. The delta of an option ranges in value from 0 to 1 for calls (0 to -1 for puts) and reflects the increase or decrease in the price of the option in response to a 1 point movement of the underlying asset price. In dollar terms, the delta is from $0 to +$100 for calls ($0 to -$100 for puts).
Delta can be viewed as a percentage probability an option will wind up in-the-money at expiration. Therefore, an at-the-money option would have a .50 Delta or 50% chance of being in-the-money at expiration. Deep-in-the-money options will have a much larger Delta or much higher probability of expiring in-the-money.
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.
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.
The Vega is a measure of the impact of changes in the Implied Volatility on the option price. Specifically, the vega of an option expresses the change in the price of the option for every 1% change in the Implied Volatility. Options tend to be more expensive when volatility is higher. When you buy options, the vega is your friend. When you sell them, the vega is your enemy.
Short premium positions like Iron Condors or Butterflies will be negatively impacted by an increase in implied volatility, which generally occurs with downside market moves. When entering Iron Condors or Butterflies, it makes sense to start with a slightly short delta bias. If the market stays flat or goes up, the short premium will come in and our position benefits. However, if the market goes down, the short vega position will go against us - this is where the short delta hedge will help.
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.
Selling options with close expiration will give you higher positive theta per day but higher negative gamma. That means that a sharp move of the underlying will cause much higher 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. You should never ignore negative gamma.
Example
Lets analyze the Greeks using one of our recent trades as an example:
Buy to open 4 ORCL July 17 2015 44 put
Buy to open 4 ORCL July 17 2015 44 call
Price: $2.66 debit
This trade is called a straddle option strategy. It is a neutral strategy in options trading that involves the simultaneously buying of a put and a call on the same underlying, strike and expiration. A straddle is vega positive, gamma positive and theta negative trade. That means that all other factors equal, the straddle will lose money every day due to the time decay, and the loss will accelerate as we get closer to expiration.
With the stock sitting at $44, the trade is almost delta neutral. Lets see how other Greeks impact this trade.
The theta is your worst enemy as we get closer to expiration. This trade had 44 days to expiration, so the negative theta is relatively small ($3 or 1% of the straddle price). As we get closer to expiration, the negative theta becomes larger and the impact on the trade is more severe.
The gamma is your best friend as we get closer to expiration. That means that the stock move will benefit the trade more as time passes.
The vega is your friend. If you buy options when IV is low and it goes higher, the trade starts making money even if the stock doesn't move. This is the thesis behind our pre-earnings straddles.
Make them Work For You
If you expect a big move, go with closer expiration. But if the move doesn't materialize, you will start losing money much faster, unless the IV starts to rise. It basically becomes a "theta against gamma" fight. When you expect an increase in IV (before earnings for example), it's a "theta against vega" fight, and the large gamma is the added bonus.
When you are net "short" options, the opposite is true. For example, Iron Condor is a vega negative and theta positive trade. That means that it benefits from the decline in Implied Volatility (IV) and the time decay. If you initiate the trade when IV is high and IV is declining during the life of the trade, the trade wins twice: from the declining IV and the time passage.
However, it is also gamma negative and the gamma accelerates as we get closer to expiration. This is the reason why I don't like holding the Iron Condor trades till expiration. Any big move of the underlying will cause big losses due to a large negative gamma.
The gamma risk is often overlooked by many Condor traders. Many traders initiate the Iron Condor trades only 3-4 weeks before expiration to take advantage of a large and accelerating positive theta. They hold those trades till expiration, completely ignoring the large negative gamma and are very surprised when a big move accelerates the losses. Don't make that mistake.
One possible strategy is to combine vega positive and theta positive trades with vega positive and theta negative ones. This is what we do at SteadyOptions. A Calendar spread is an example of vega positive theta positive trade. When combined with a straddle trades which are vega positive theta negative, a balance portfolio can be created.
Conclusion: when you trade options, use the Greek option trading strategies to your advantage. When they fight, you should win. Like in a real life, always know who is your friend and who is your enemy.
The following videos will help you understand options Greeks:
Related articles:
Options Trading Greeks: Theta For Time Decay Options Trading Greeks: Delta For Direction Options Trading Greeks: Gamma For Speed Options Trading Greeks: Vega For Volatility
We invite you to join us and learn how we trade our Greek options trading strategies. We discuss all our trades including the Greeks on our options trading forum.
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By Mark Wolfinger
For the option buyer, the opposite is true. By owning an option, the trader has the potential to score a big profit—if the underlying asset makes the anticipated move. However, options are wasting assets and lose value each day. For the option owner, the passage of time is a negative factor and once the option is bought, the desired price movement must occur before the option expires, and the sooner the better. The underlying does not have to move to any specific price if the plan is to sell the option well before expiration (recommended). Too many option owners buy their options and hold all the way to the end, thereby sacrificing every penny paid for time premium.
What is Options Time Decay?
However, positions with that positive time decay are subject to losing money when the underlying asset does not behave as anticipated. These losses are directly related to negative gamma (The Greek that measures the rate at which delta changes. Negative gamma tells us that we get longer as the market falls and shorter as the market rallies.) For our waiting period to prove profitable, it is necessary for the market to ‘behave.’ Translation: The market must not stray too far from the strike prices in our position.
For positions where the short options have only a single strike price (calendar, butterfly, credit spread), the underlying must remain near, or move towards that strike price for maximum profit. There is leeway, but losses occur when the underlying moves to far from that strike
For positions with two such short strikes (Condor, for example), the underlying must remain between those strike price levels (preferably not near either) for the waiting period to be successful And that’s the problem. Waiting for options to decay is ‘easy,’ but can be a risky proposition. In the real world, things are not simple. The underlying stock or index may approach the strike price of our short option(s). That can be a frightening situation—especially for the rookie trader who is experiencing this for the first time. The natural—and appropriate—reaction is to relieve the fear by reducing or eliminating risk.
Being willing to take that defensive action is an essential part of managing risk for these positive-theta (time decay is on your side), negative-gamma trades. When things go well, traders who hold positive theta positions can make a good living. However when markets become volatile or unidirectional, losses can accumulate quickly. To survive the trader has to become a skilled risk manager.
It’s a fine line between getting out of a position that has become too risky to own and holding onto the trade for a little longer, looking for a market reversal.
The biggest problem for the rookie trader is adopting this mindset: “The market cannot move any more in this direction. Look how far it has come already. I know there is a reversal coming very soon.”
Believe me, it is an easy mindset to develop. We always prefer to believe that we made good trade decisions and that our trades will work out well in the end. And perhaps they would become profitable when all is said and done. However, the risk of substantial loss has become high; too high for the disciplined and successful trader. He knows that something bad may happen before that happy ending is reached. For example, it is not uncommon to see a stock rally to ‘squeeze the shorts’—only to fall back to earth. That happens. But why take the risk? Why put yourself in position to take a big loss?
The proper mindset is: “I don’t know whether the market is moving higher or lower from here. I have a bias, but I just cannot afford to take that chance. I’m going to get out of my risky trade and take the loss. I will survive to trade (and prosper) in the future. If I want to place a wager on that market bias, I can find a far less risky way to make that play than holding onto my current (losing and risky) position.”
Dialog
During a discussing on position management, one trader offered the following: “Theta is how I track my progress for any trade.”
I get it. We watch the value of our account grow steadily. We watch the price of the options we sold move towards zero (or the price of the spread we own increase in value). It is so easy to believe that you discovered the Holy Grail of trading.
This euphoria can go on for a long time. Please remember this:
There is no free money. All trades involve risk. A winning streak can end suddenly..
Theta is the trader’s REWARD for successfully having another day pass with no relevant consequences. Yes, you can watch the profits accrue day after day. There will be periods when the trade plan (hold and wait) works perfectly. That is not as beneficial as it seems because it may bring unrealistic (and dangerous) expectations, such as falsely believing that trading credit spreads is far too conservative and that there is so much more money to be made by selling naked options.
When the trader does not pay for the father OTM option that completes the spread, the net premium collected is significantly larger. That increases profit potential. The difficulty is that risk has grown enormously and someone who has not lived through a violent market may go bankrupt in a heartbeat. That less-experienced trader often brushes aside all warnings because of past success.
As you watch the days pass and profits accumulate, it is easy to lose sight of the fact that risk (defined as the amount of money that can be lost) is just as high as it was earlier. The factor that changed as time passed is that the probability of incurring that loss is now smaller.
It only takes ONE bad day to kill the profits from weeks of collecting theta. Translation, as you continue to wait, a two standard deviation move (expected about once in every 20 trading days) could turn your winners into losers.
When a trader watches her account grow every day, she becomes blind to risk. Trust me. I have been in your shoes and watched positive theta grow my account. Then I watched as theta’s Greek counterpart (gamma) withdrew all the profits, and more, from that same account.
Warning: Recognize the danger of being mesmerized by profits. Risk is not diminished as time passes. The probability of losing has decreased, but that is not the same thing. The chance of losing does not reach zero until expiration has passed or the position has been closed.
Conclusion
Please be aware of risk. Do not grow overconfident. Time decay is your friend, but it is not your savior. Owning positive theta positions can be a very profitable strategy. The warning is to be certain that you never fail to recognize just how much money can be lost from any trade.
Traders interested in trading options should keep in mind that the expiration date of a contract affects its value. If you’re buying options very close to their expiration date, you should be prepared for their values to drop quickly.
Traders can choose to capitalize on this by selling options close to their expiration date, but you have to be willing to accept the risks—including the potentially unlimited losses—involved with selling certain options.
This post was presented by Mark Wolfinger and is an extract from his book The Option Trader's Mindset: Think Like a Winner. You can buy the book at Amazon. Mark has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Mark has published seven books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University.
Related articles
Trader Mindsets How Much Can I Earn With Options? Trader’s Mindset: Oblivious To Risks Managing A Losing Trade Maybe The Market Will Turn Around Trader’s Mindset: Always Collect Cash The Art Of Trading Decisions Managing Risk For More Than One Position My Philosophy On Options Education Trade Decisions: Risk Or Profits? The Big Loss The Options Greeks: Is It Greek To You? Options Trading Greeks: Theta For Time Decay -
By Kim
The Delta is one of the most important Options Greeks.
General
The delta of an option is the sensitivity of an option price relative to changes in the price of the underlying asset. It tells option traders how fast the price of the option will change as the underlying stock/future moves.
Option delta is usually displayed as a decimal value between -1 and +1. Some traders refer to the delta as a whole number between -100 and +100. Delta of +0.50 is the same as +50.
The following graph illustrates the behaviour of both call and put option deltas as they shift from being out-of-the-money (OTM) to at-the-money (ATM) and finally in-the-money (ITM). Note that calls and puts have opposite deltas - call options are positive and put options are negative.
Call and Put Options
Whenever you are long a call option, your delta will always be a positive number between 0 and 1. When the underlying stock or futures contract increases in price, the value of your call option will also increase by the call options delta value. When the underlying market price decreases the value of your call option will also decrease by the amount of the delta. When the call option is deep in-the-money and has a delta of 1, then the call will move point for point in the same direction as movements in the underlying asset.
Put options have negative deltas, which will range between -1 and 0. When the underlying market price increases the value of your put option will decreases by the amount of the delta value. When the price of the underlying asset decreases, the value of the put option will increase by the amount of the delta value. When the underlying price rallies, the price of the option will decrease by delta amount and the put delta will therefore increase (move from a negative to zero) as the option moves further out-of-the-money. When the put option is deep in-the-money and has a delta of -1, then the put will move point for point in the same direction as movements in the underlying asset.
If you have a call and a put option, both for the same underlying, with the same strike price, and the same time to expiration, the sum of absolute values of their deltas is 1.00. For example, you can have an out of the money call with a delta of 0.36 and an in the money put with a delta of -0.64.
Delta Sensitivity
As a general rule, in-the-money options will move more than out-of-the-money options, and short-term options will react more than longer-term options to the same price change in the stock.
As expiration nears, the delta for in-the-money calls will approach 1, reflecting a one-to-one reaction to price changes in the stock. Delta for out-of the-money calls will approach 0 and won’t react at all to price changes in the stock. That’s because if they are held until expiration, calls will either be exercised and “become stock” or they will expire worthless and become nothing at all.
As expiration approaches, the delta for in-the-money puts will approach -1 and delta for out-of-the-money puts will approach 0. That’s because if puts are held until expiration, the owner will either exercise the options and sell stock or the put will expire worthless.
As an option gets further in-the-money, the probability it will be in-the-money at expiration increases as well. So the option’s delta will increase. As an option gets further out-of-the-money, the probability it will be in-the-money at expiration decreases. So the option’s delta will decrease.
It is important to remember that Delta is constantly changing during market hours and will typically not accurately predict the exact change in an option’s premium.
Delta as Probability
Delta can be viewed as a percentage probability an option will wind up in-the-money at expiration. Therefore, an at-the-money option would have a .50 Delta or 50% chance of being in-the-money at expiration. Deep-in-the-money options will have a much larger Delta or much higher probability of expiring in-the-money.
Looking at the Delta of a far-out-of-the-money option is a good indication of its likelihood of having value at expiration. An option with less than a .10 Delta (or less than 10% probability of being in-the-money) is not viewed as very likely to be in-the-money at any point and will need a strong move from the underlying to have value at expiration.
As mentioned, the sum of absolute values of delta of a call and a put with the same strike is one. This is in line with the probability idea. When you have a call and a put on the same underlying and with the same strike price, you can be sure that one of them will expire in the money and the other will expire out of the money (unless, of course, the underlying stock ends up exactly equal to the strike price and both options expire exactly at the money). Therefore, the sum of the probabilities should be 100% (and the sum of the absolute values of deltas should be one).
Just for clarification, delta and probability of expiring in the money are not the same thing. Delta is usually a close enough approximation to the probability.
Example
If the delta on a particular call option is .55, then, all other things being equal, the price of the option will rise $0.55 for every $1 rise in the price of the underlying security. The opposite effect is also seen as for every $1 decline in the price of the underlying the option will lose $0.55.
If the delta on a particular put option is -.45, then, all other things being equal, the price of the option will rise $0.45 for every $1 fall in the price of the underlying security. As with call options the obverse scenario is also true.
List of delta positive strategies
Long Call Short Put Call Debit Spread Put Credit Spread Covered Call Write
List of delta negative strategies
Long Put Short Call Put Debit Spread Call Credit Spread Covered Put Write
List of delta neutral strategies
Iron Condor Butterfly Short Straddle Short Strangle Long Straddle Long Strangle Long Calendar Spread
Summary
Positions with positive delta increase in value if the underlying goes up Positions with negative delta increase in value if the underlying goes down An option contract with a delta of 0.50 is theoretically equivalent to holding 50 shares of stock 100 shares of stock is theoretically equivalent to an option contract with a 1.00 delta
Watch the video:
Related articles:
The Options Greeks: Is It Greek To You? Options Trading Greeks: Theta For Time Decay Options Trading Greeks: Vega For Volatility Options Trading Greeks: Gamma For Speed
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