Those Crazy Greeks
The world of options is dominated by four mathematical variables:Delta, Gamma, Theta and Vega. Collectively they are known as ìTheGreeks,î although options traders often add their own colorfuladjectives when their P&Lís begin to sink.
What makes these fourvariables so important? Taken together, they can provide an experiencedtrader with a comprehensive risk analysis in a single glance. Quitesimply, if you want to trade options, then you have to master TheGreeks.
Delta signifies the rate of change in an optionís price as it relatesto movements in the underlying asset. Most theoretical programs expressan optionís delta as a number from 1-100. A delta of one indicates thatan option will change its price by one cent for every one-dollarmovement in the underlying.
An option with a delta of a 100 will movein perfect correlation with the underlying. Delta is an importantvariable because it shows the directional risk of an options position,as well as how many shares or futures are required to hedge that risk.(Delta also measures the probability of an option expiring in themoney, but that is a discussion for another day.)
Options are not static instruments. Their characteristics and risksvary with fluctuations in the underlying asset. Gamma is used tomeasure the rate of change in Delta as the underlying moves.
Gamma canbe expressed as either a positive or a negative number. A positiveGamma indicates that changes in Delta will be positively correlated tomovements in the underlying price. A negative Gamma indicates thatchanges in Delta will be inversely correlated to movements in theunderlying price.
Theta is where things get confusing. Theta measures how much extrinsicvalue an option will lose every day until expiration. This steadyerosion of value is also known as time decay. Time decay is difficultto calculate accurately and most theoretical models for theta breakdown around expiration.
Traders use theta to estimate the impact oftime decay on their P&Ls. Gamma and Theta have an inversecorrelation. A positive gamma position will lose money every day due totime decay while a negative Gamma position will collect money fromtime decay.
Vega is undoubtedly the king of all The Greeks. Vega measures theimpact on an options price of a one-percent change in volatility.Since most option traders are actually volatility traders,understanding the intricacies of vega is crucial to long-termprofitability.
DIY Greeks For The Retail Investor
Some of you out there might be wondering how to calculate your ownGreeks. Thankfully, there are a wide-variety of theoretical programsavailable for both retail and institutional customers. Which program is right for you depends on your understanding of options and the intricacy of yourtrading style.
If you are a retail customer, then your broker probably offers a free theoreticalprogram. These programs range in quality from nearly useless to extremely powerful. In fact, the best retail offerings can often rival the professional theoretical programs on the market. The relentless march of technology has put a dazzling array of professional-grade tools inthe hands of the average retail investor.
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