Introduction
Trading options can be risky. That may be unexpected as the majority of individuals who venture into it actually do so because they want to avoid the immense risks in other financial assets such as stocks. However, when done right, it can be tremendously profitable, too.
Whether you are a woman actively engaged in the labour force looking for a side-hustle or a stay-at-home Mum thinking of a way to earn, options trading is a reasonable consideration to make. But, how can you increase your odds of success? Know how to apply the “Greeks.”
What are the “Greeks”?
In options trading, predicting price moves can be difficult. That is because the price of an option tends to lag behind that of the asset it underlies. However, to understand the potential rewards and risks of options, traders use delta, gamma, vega, and theta.
Those terms, collectively referred to as the “Greeks,” are highly effective as they help options traders to gauge the response of price to a myriad of measurable market factors. So, how can you analyze them to make good trades?
How to Analyze the “Greeks”
Delta is a measure of the sensitivity between the price of an option and the price of the security that underlies it. Usually represented as a number between -100 and +100, delta seeks to answer: by how much dollar amount will the value of an option which has 100 shares of the underlying stock rise or fall? For call options, deltas are positive; for put options, on the other hand, they are negative.
Hence, the further the option is in the money, the higher delta is. That is why out-of-the-money options generally have deltas of 20 or less. While at-the-money options tend to have deltas of around 50, deep-in-the-money options have deltas as high as 80 or more.
So,
- Assuming you own 10 call options trading at $20 with a strike price of $404. If the underlying stock, currently trading at $400, rises to $402 and delta is 50 (0.5, meaning that for every $1 increase, the call rises by $0.50), the call options will now trade at $21, translating to a total profit of $10 for you.
Delta is so important that gamma helps to track its rate of change for each one-point increase in the asset it underlies. Thus, gamma is an effective tool for predicting changes in it. Although it is positive for both call and put options, for at-the-money options, gamma tends to be higher; however, for in- and out-of-the-money ones, it tends to go lower. Therefore, the lower gamma goes, the further the option is either in or out of the money.
So,
- Assuming you own a call option trading at $20 with a strike price of $404. If delta is 50 (0.5) and gamma is 10 (0.1) and the underlying stock, currently trading at $400, rises to $402, the call option will now trade at $21 and the new delta will be 70 (for every $1 increase in the price of the stock, delta rises by gamma which is 10 here).
Theta measures the dollar amount an option loses with the passage of each day. As a result, it increases as the expiration date of an at-the-money option gets close. However, for an out-of-the-money option, it reduces as the expiration date approaches. Finally, vega, the Greek term used to denote the volatility of options, helps to reflect changes in the price of an option due to changes in its volatility. Volatility tends to affect at-the-money options more than it does out-of-the-money ones.
So,
- For your call option trading at $20 with a $404 strike price, a vega of 10, and a change in underlying volatility of 1% (from 14% to 15%), the option price would now be $21.
Conclusion
Here, you have learned about the “Greeks.” Now, you have gained the preliminary knowledge needed to apply them in your options trading career. With them, henceforth, you should be able to make better trades.