Category: Option Greeks

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Option Greeks

What Do You Know About Option Theta?

Option Theta
Greek Small Letter Theta - Vector multicolored outline font with glowing effect isolated on blue background. EPS10

What do you know about option theta? For many, it can be the easiest option greek to understand, but for many others it is the most difficult. Let’s take a quick look below and, let’s hope, clear up some confusion.

Theta Definition

Theta measures the rate of decline in the value of an option due to time passing. Keeping it simple, for every day that passes, theta should decrease the option’s premium by the amount of theta. Long options, both calls and puts, have negative theta. Short options, both calls and puts, have positive theta. How can we use this as part of our option trading? Theta is also highest at-the-money (ATM) and smaller out-of-the-money (OTM) and in-the-money (ITM).

Keeping It Simple

Time passing decreases option premium, keeping all other variables constant. Long options have negative theta, so time passing will decrease the premium. To make a profit on a long option, it needs to be sold for more than it was purchased. Short options have positive theta because premium is decreasing, and that is beneficial for a short position. A profit is made if premium is sold and bought back at a lower amount or it expires worthless. It sounds simple and it really is. If you remember the above, you will have a solid grasp of theta.

Multiple Thetas

But what if there are multiple legs on your option trade? If your positive theta is bigger than all the negative theta, time passing helps the position whether it be a debit or credit spread. If your negative theta is bigger than all the positive theta, time passing hurts the position for either a debit or credit spread.

Don’t Complicate Things

Theta is one of those greeks that may be easy to understand on paper but a little confusing when it comes to whether it is hurting or helping the position, particularly where spreads are concerned. Remembering positive and negative and whether it is a debit or credit position will make it easier to understand.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

Categories
Option Greeks

Rho: It’s Back!

Option Rho
Abstract 3D illustration. Physical density as a chip with electronic tracks on a blue background.

I haven’t had to think about this one for a while. But after 14 years, it’s back in play: the option Greek rho.

The Option Greek Rho

Let’s just dig right in, shall we? Rho is the option Greek that measures an option position’s sensitivity to a change in interest rates. It works like some of the other Greeks (theta and vega) measuring the option-value sensitivity in dollars and cents of option premium. For example, if an option has a rho value of 0.35 and interest rates change by 1%, the option value changes by 35 cents.

Calls have positive rho, when you’re long them anyway, and long puts have negative rho. That means when interest rates go up, call values go up and put values go down.

How Do Interest Rates Affect Option Prices?

There’s a lot to unpack here. First of all, let me correct an intentional error. Rho—in fact all the Greeks—affects option values, as opposed to prices. Prices are set by the market and are centered around value. That’s fodder for a future post. But I figured I’d throw it out there just to be accurate.

The rationale for why options values are affected by interest rates is rooted in the concepts of hedging, put-call parity and synthetics. But for simplicity, consider this concept: If you’re bullish, you can buy the stock and tie up a lot of cash, or you can buy a call using a fraction of it. Let’s put some numbers on that.

Imagine you’re considering either buying 100 shares of a $150 stock or buying a 3-month, 150-strike call at $4.75. The 100 shares would cost you $15,000. The call will cost you $475. If you bought the call, you could actually take that remaining $14,525 and put it into a money market account and earn interest on it. (This is an argument we couldn’t make up until recently.)

It’s very quantifiable. And when you start thinking about it, it probably becomes intuitive that the higher the interest rate, the more money you make squireling away that cash. Consequently, as interest rates rise, calls get more valuable.

A similar argument can be made for puts. If you were to short stock (and are a professional trader or a big-enough retail trader with some clout with your brokerage firm) you would earn interest on the cash you receive when you sell those borrowed shares. This is called a “short stock rebate.” But if you buy the put, you don’t get all that cash, and thus don’t get the interest. (In fact, you have to pay a comparatively small amount of cash.) So as interest rates go higher, the put becomes less valuable, compared with shorting the stock.

Rules of Thumb for Rho
  • As interest rates rise, calls get more expensive and puts get cheaper.
  • As interest rates fall, calls get cheaper and puts get more expensive.
  • A one-percent change in the interest rate changes the option by the value of its rho.
  • Rho affects longer-term options more than shorter-term options.
Put-Call Parity and Rho

Let’s not get all mathematical here. But I do want to point out an interesting phenomenon. You may have read that when options are right at the money, the call and put values are equal. But with equity options, it’s not really like that. The call value is actually higher than the put value. The higher the interest rate the greater the disparity.

Interest Rates and Rho

BTW, what interest rates are we talking about? Well, here’s another little textbook fallacy. If you have already read up on interest rates and rho, you probably read something along the lines of “…when the risk-free rate, the rate of U.S. Treasury notes, changes, options change by the value of rho, blah, blah, blah…”

Well, I’m here to tell you that’s a bunch of crap. What a trader really needs to use is the actual interest rates associated with his or her account. If a professional option trader is borrowing money (which they may have to do to carry the long stock they need to hedge their deltas, for example), they’d use the actual interest rate they are paying. Or if they are receiving interest on extra cash they have in their account (maybe they are short a lot of stock), they’d use that short stock rebate rate.

Options educators / writers just say “the risk-free rate” for simplicity, apparently. But it’s real money. Traders, especially big traders need to use the right numbers to get accurate values to estimate interest-rate risk. When I was making markets, I can recall a day when I made (or lost, I forget) around $10,000 when the Fed announced a surprise rate hike.

And, so there it is too: The connection between the “risk-free rate,” in this case the discount rate, and “interest rates,” the ones you’d actually use, the ones in your account. Clearly, they are related and when one goes up probably the other ones do too. But it’s not an exact correlation. (Anyone who has shopped for a mortgage over the past three months has noticed that. Mortgage rates went up earlier and more than the interest rate the Fed raised.)

How Does Rho Affect Your Options Positions?

If you were thinking about it while reading the Rules of Thumb section of this post you may have already figured this out. But unless you have longer-term options, this whole rho thing isn’t likely to be a really big deal. And bigger dollar amount underlyings are intuitively affected more, as there is more interest on a $2,000 stock than a $20 stock. And, of course, bigger positions are affected more too. But hey.

You’ll definitely begin making or losing at least some money as a result of interest rates changing. You might as well understand why and how maybe you can preemptively think about it in advance and maybe change random P&L events to ones you can take advantage of. In trading knowledge is power. Put it to good use, my friend.

Dan Passarelli
Founder and President
Market Taker Mentoring, Inc.

Categories
Bear Call Spread Credit Spread Option Greeks

Delta Can Make or Break Credit Spreads

One of the biggest topics I discuss in MTM’s daily Group Coaching class is how delta can make or break a credit spread. Option traders associate credit spreads as mostly a positive theta trade. I am going to show you why I believe delta is the bigger factor usually. When you think about selling a vertical credit spread as an option trader, probably the first thing you think of is positive theta. Of course, positive theta is a very important aspect to a potential profit. But if there are more than a couple of days to go to expiration, there is another option greek that can get you to your profit destination quicker than positive theta.

Vertical Credits

There are two types of vertical credit spreads: the bull put and the bear call. When selling a call credit spread (bear call), an option trader believes the stock will stay below a certain area like resistance for maximum profit. The trade is initiated by selling a call and buying a higher strike call with the same expiration. A put credit spread (bull put) is created by selling a put and buying a lower strike put with the same expiration. The option trader believes the stock will stay above a certain level like support for maximum profit. Let’s look at an example below.

Bear Call Example

Suppose an option trader expects the stock to stay below $220 by expiration in 10 days. He sells the 220 call and buys the 225 call.

The maximum profit on the trade is the credit received. In this case it is $1.30 (3.20 – 1.90) or $130 in real terms if the stock closes at $220 or below at expiration. The positive theta on the trade is 0.05 (0.27 – 0.22) a day. That means for every day that passes the spread’s premium will decline by the theta amount. Not bad right? But look at the negative delta on the trade. It is 0.11 (0.35 – 0.24). That means if the stock does move a $1 lower and further from the 220 short call strike, the spread’s premium will decrease by that amount.

So, think of it this way, if the stock fell $2 over 2 days, the premium would decline $0.22 (0.11 X 2) from theta and 0.10 (0.05 X 2) from theta. Starting out with a credit of $1.30 and keeping all other variables constant the new premium would be $0.98 (1.30 – 0.22 – 0.10). A profit could be made of $0.32 or $32 in real money. The negative delta of the position contributed more to the profit than the positive theta in this case and truth be told that should happen more times than not.

Final Thoughts

Positive theta is very important when it comes to potential profit when trading vertical credit spreads. It will always be on your side provided the position stays above breakeven. That said, an expected move away from the short option as forecast can make the position a whole lot more profitable much sooner before expiration than theta alone.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

Categories
Bull Call Spread Option Greeks Stop Loss Orders

A Warning About Selling Naked Puts

With another wave of earnings right around the corner, I feel the need to caution option traders and investors about selling “naked” or cash-secured puts over an earnings announcement. Whether you refer to it as writing or selling naked options, many option traders do not understand the risk. Selling a put option without having a position in the underlying stock or being long any options on the stock is considered a naked position. For example, if a trader is writing naked calls, he is selling calls without owning the stock. If the trader did own the stock, the position would be considered covered.

Can They Be Low Risk?

Can selling naked puts be low risk? The better question might be, what do you consider low risk? If you have invested money in the market, you are at risk. Traders often think it is a low-risk strategy that can offer consistent profits and indeed it can. Selling out-of-the-money (OTM) vertical credit spreads can be considered low risk because of the potential high probability of success. However, selling naked options can be dangerous, especially for new option traders, and should only be considered by more advanced option traders and those with large trading accounts.

Short-option premium can seem like an easy way to make a profit in trading. What traders forget is that the premium received from selling options is not theirs to keep, and there is substantial risk until the position is closed for a profit or expires worthless. Even though the premium may seem like a gift, it is not by any means. The risk of selling naked options can be significant.

Implied Volatility

 When the market moved lower recently, implied volatility levels and option prices increased. When the market rallied again, both dropped lower. When implied volatility is considered high, it can be a good time to sell premium like a naked option. Generally, after an earnings announcement, implied volatility starts to decline, which is good for naked option traders. That said, it is considered even more speculative if the position is held over the earnings announcement. A volatility event like an earnings announcement can produce some unpredictable price action for stocks.

Here’s an Example

Goldman Sachs Group Inc. (GS) is expected to announce earnings on April 14. At the time of this writing, the stock is trading around $330 and has a potential support level around $325 from previous pivot levels. A trader can sell 10 April (April 14th) 325 puts for 5.85 each. As long as GS stays at or above the $325 level, the premium of $5.850 (5.85 X 10) is the trader’s to keep. In fact, GS could even drop below the $325 level and the trader could profit. The premium offsets potential losses and makes the breakeven point of the trade $319.15 (325 – 5.85).

With a volatile move, particularly after earnings, many naked option positions can wipe out a significant part of a trader’s account. What many traders fail to realize or forget is that each option contract usually represents 100 shares of stock. Getting back to the example above, if GS traded down to $315 (just $10 below the strike, which is not unheard of) at expiration because of earnings, a loss of $4,150 ((10 X 1000) – 5,850) would be incurred because of the 10 contracts. An option trader who thought he or she would easily make $5,850 because of the odds has now experienced a sizable loss.

Here’s the Gist

Option traders need to be extremely careful if they choose to sell naked options, especially over a volatility event such as earnings when premiums are overpriced. If a trader decides the risk of selling naked options is worth the reward, the best environment for selling option premium is when implied volatility is higher than historical levels but not over an earnings announcement. Many uninformed “experts” out there promote this type of activity as relatively safe. But let me tell you, the risks of selling uncovered options are much greater than many sources claim.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

Categories
Bull Call Spread Option Greeks Stop Loss Orders

Hard vs. Mental Stops for Option Traders

When to choose hard vs. mental stops as an options trader is a topic that comes up frequently in my daily group coaching classes and one-on-one coaching sessions. The truth is, it is not an easy answer. When it comes to options, stop losses can be a little tricky as compared with an investor who buys and sells stock.

Bid/Ask Spreads

For one thing, bid/ask spreads tend to be a little wider for options, which means there is more ground to make up than there would be for many equities, which have a tighter bid/ask spread. There are plenty of times in options trading when you are thankful to just get back to breakeven on some trades because of the spreads. Imagine an option position that has four legs like an iron condor. If the bid/ask spreads are wide, think how difficult it would be to do a hard or mental stop loss trying to middle the market. What is “too spready” is up to each option trader to decide. Below is a general rule of thumb I use when it comes to stop losses and options.

Outrights

When buying or selling a single-legged option, I tend to use a hard stop if the bid/ask spread for the option is reasonable. You will have to decide what is reasonable and that is a discussion for another day as stated above. I will put in a sell stop loss for long positions and a buy stop loss for short positions. Since there is only a single leg, the bid/ask spread is usually tighter. The screenshot below is a stop loss on a long call position. The current bid/ask spread is only 0.03 wide (that can widen, however) so there is less chance for slippage or a worse fill with the exit order set if the position declines to 1.00 or lower by becoming a market order.

When buying or selling an option spread, a mental stop is usually more beneficial because the bid/ask spreads tend to be larger due to multiple legs. If the bid/ask spreads are generally tight, I still consider using a hard stop especially if I am fortunate enough to have previously taken a profit on some of the position. The screenshot below shows a potential vertical call debit spread (bull call) and a stop loss. Notice that the bid/ask spread is larger than the long call listed above. Here the stop loss is set to exit if the position drops to 1.00 or lower in value again. The bid/ask spread is now 0.16 wide instead of just 0.03 like above.

Finally

Whether you choose to use a mental or hard stop is completely up to you, but consider how wide the bid/ask spread is as well. In addition, some option traders might sway from their mental stops when that level is tested and actually lose more money because of lack of discipline. That too is a discussion for another time. I hope this will give you a few things to think about. The most important part is that you have a stop loss (mental or hard) in the first place.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

Categories
Bull Call Spread Option Greeks

Option Vega Works Both Ways

Option Vega

If you have traded over the past several weeks, you have undoubtedly noticed how volatile the market has been. As an option trader, you are or probably should be familiar with how implied volatility changes can affect option prices. Below we will take a look at a topic I covered in class a couple of weeks ago when the market was seemingly all over the place.

Vega Defined

Option vega is the measurement of the option’s price sensitivity to changes in the volatility of the underlying. To keep it simple, like I generally like to do, vega changes the premium of the option for every 1% change in implied volatility (IV). If IV rises, option prices rise and vice versa. With the market and stock rising and falling unconsciously lately, you can see how option prices may be affected. Generally, when markets and stocks rise, IV drops and when market and stocks fall, IV rises.

SPY Example

On Thursday, Feb. 24, the market and the SPDR S&P 500 ETF (SPY) gapped lower to start the session. A chart of the ETF showed it had moved lower for several sessions and might have been a tad extended to the downside. In addition, the ETF had some potential support where it was currently trading that might provide a boost higher again. With a big move lower, IV levels were elevated along with option prices. If a move higher was expected, IV would most likely drop to some degree as well. A long call option was considered, but a long call has positive vega and an IV drop would decrease the premium.

Bull Call Spread

We also looked at a bull call spread. In this case, we modeled out an Apr-14 420/440 bull call spread. Without getting into too much detail other than vega, there are clearly trade-offs between a long call and a bull call spread with one being the max profit of a long call is unlimited and the spread limited. But here we are focused on the vega position. The spread would have both positive (long call) and negative (short call) to limit vega exposure compared with the long call on its own. With an IV drop expected, neutralizing the vega position versus just a positive vega position seemed like the correct choice. On a side note, the SPY moved over $20 higher by Friday’s close, which did wonders for a profitable position.

Finally

If you have a positive vega position and expect an IV drop, a spread can offset that exposure. If you have a negative vega position and expect an IV rise, a spread can offset that exposure as well. However, as you can see, a spread can also limit gains. As always, everything in options is a trade-off.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

Categories
Option Greeks

Implied Volatility – How Traders Can Benefit From It

Implied volatility - VIX example

Implied volatility is the forecast of a likely movement in the underlying. Keeping it simple, implied volatility is how options are priced. When IV is higher, option prices are higher and vice versa. Generally, when the market moves lower, option prices and IV increase as demand goes higher for protection or a hedge. When the market is steady or moving higher, generally IV levels and option prices are lower.

Implied volatility is analyzed using a volatility chart. A volatility chart tracks the implied volatility and historical volatility over time in graphical form. It is a helpful guide that makes it easy to compare implied volatility and historical volatility.

The greek vega changes option premium based on changes in implied volatility. Keeping it simple yet again, for every 1% change in IV, vega will increase or decrease option premium by that amount. An increase in IV has vega increasing the premium and vice versa. Below we will take a closer look.

Implied Volatility When You Buy and Sell an Option

When you buy an option, you have positive vega. An increase in IV in which vega would increase the premium is beneficial. When you sell an option, you have negative vega. A decrease in IV in which vega would decrease the premium is beneficial. The same is true of a spread. If the long option vega is greater than the short position vega, the position has positive vega and vice versa. The bottom line is when you have positive vega overall, an increase in IV is desired; and when you have negative vega overall, a decrease is beneficial regardless of the option strategy. Let’s take a look at one below.

Bull Call Spread – Long Leg

A bull call spread is when a trader buys one call and sells another that has a higher strike price with the same expiration. The long call would have positive vega and an increase in IV for that option would be beneficial for the position.

Bull Call Spread – Short Leg

The short call would have negative vega and a decrease in IV for that option would be beneficial for the position. In addition, if the IV for the long option is lower than the IV for the short option, the cost of the spread would be less than is they were even or the IV was higher for the long call. This would be an advantage because the risk and cost would be lowered and the max profit would be greater too.

How Does the VIX Affect Implied Volatility?

The VIX Index measures the 30-day expected volatility of the stock market derived from the prices of the S&P 500 Index call and put options. It is probably the most recognized measure of volatility. Take a look at the VIX chart below.

Implied volatility - VIX example

Now take a look at the S&P 500 ETF (SPY) for the same period below.

For the most part, when the SPY moved higher, the VIX moved lower or stayed steady; and when the SPY moved lower, the VIX moved higher and returned lower after the SPY rallied higher again. Basically, when the market falls, options prices and the VIX increase; and when the market moves higher or stay steady, option prices and the VIX tend to fall or remain steady.

Implied Volatility Examples

Coming back to the bull call spread example from above, here is a recent option chain for AMC Entertainment Holdings Inc. (AMC). A Sep-17 45/50 bull call spread was looked at below.

Notice the IV for the long 45 call is 136.6% and the IV for the short 50 call is 150.2%. A cheaper call is being bought than sold. The cost of the trade currently is 2.00 (5.55 – 3.55), which gives the trade a max profit of 3.00 (5 (Diff in the strikes) – 2 (cost)) if the stock is trading at or above $50 at expiration. Because of the favorable IV skew, the risk/reward is improved. The breakeven for the this spread at expiration is $47 (45 + 2). Partially due to the favorable IV skew, the stock is trading above that level ($47.64) at the time of this screenshot.

Conclusion

Knowing how to read IV levels, take advantage of IV skews and forecast what IV will do in the future can be huge advantages for an option trader. The fact is, just knowing how to minimize the effect of IV when applicable can make a difference between a winning and losing option trade.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

Categories
Option Greeks

Option Vega – How It’s Different From Other Option Greeks

Option Vega

Option vega, like option gamma, is one of those option greeks that often confuse option traders. But it does not have to be that way. Below we will break down the dynamics of vega so that even the most basic of option traders will have a clearer picture of this mystery greek.

What Is Option Vega and How Does It Work

Option vega measures the impact implied volatility (IV) has on option premiums. Keeping it simple, for every 1% change in IV, vega will change the premium by that amount. If IV rises 1%, option premium will rise by the amount of vega, and if IV falls 1%, option premium will drop by the vega amount. For example, if IV is 35%, vega is 0.05 and the option premium is 2.50, a 1% increase from 35% to 36% will increase the premium by 0.05, or to 2.55. Option traders love when IV increases for long option positions and decreases for short option positions. Because of this, long options, both calls and puts, have positive vega. Short options, both calls and puts, have negative vega.

Just like option gamma and option theta, vega is highest at-the-money (ATM) and smaller in-the-money (ITM) and out-of-the-money (OTM). But unlike gamma and theta, vega gets bigger further out to expiration. So a longer expiration means a larger vega number.

Buy low and sell high applies to IV as well. As an option trader, you want to buy premium when IV is considered low or cheap. Once in the position, you prefer IV to rise to increase your premium. As a premium seller, you prefer IV to be high or expensive when premium is sold. Then you prefer IV to decline after the position is initiated. If an option trader believes IV will rise after initializing the position, a positive vega position is preferred. If he or she believes IV will fall after initializing the position, a negative vega position is optimal. But what if the position has positive vega and an IV decrease is forecast or vice versa? Let’s take a look.

Neutralizing Option Vega

There is a saying in Chicago where I am from that if you don’t like the weather, wait 30 minutes and it will change. The same can be said about the option greeks including vega. The way to decrease and sometimes totally neutralize vega is by using a spread and in particular a vertical spread.

Let’s keep this lesson fairly simple. Option prices are affected by IV, as we know. If IV is higher than normal, option prices tend to be high. If IV is in the lower part of its range, option prices tend to fall. Let’s pretend the market just had a big sell-off with prices dropping and IV rising. After the drop, an option trader now believes stocks will reverse and move higher again with IV levels and option prices moving lower again.

 A long call position with positive option delta can profit from a move higher. But the position also has positive vega (long positions have positive vega) and IV is expected to come down. What is an option trader to do?

Take a look at the option chain below.

Option Vega

The 245 strike call could be purchased for 7.15 and have a positive vega of 0.31. IV is currently at 20.51%. What if the stock rallied as was forecast but the IV dropped 5% down to 15.51%? Based on the current vega of 0.31, 1.55 (0.31 X 5) would be subtracted from the call premium. But what if a spread (in this case a bull call) was initiated?

In the example above, the 245 call is bought and the 250 call is sold. Take a look at the vega on the position. Before selling the 250 call, the position had a positive vega of 0.31. After selling the 250 call, the vega position is essentially neutral (0.31 – 0.31). So if IV drops, the position will not be as affected as it was before when the position had positive vega and would have lost premium. Of course, the max profit is now limited and the positive delta is also smaller as well, but universal IV fluctuations will not make a major impact on the position.

Final Thoughts

This is just one way to offset vega risk, but it can be rather effective, particularly in down markets when a move higher is expected. The same is true when IV is low and a rise in IV and fall in the market is expected. Negative vega positions can be offset with a long positive vega position. As I like to say, when in doubt, spread it out.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

Categories
Option Greeks

How to Use Option Theta in Your Trading

Option Theta - long call

Trading options can be a long and frustrating journey without discipline and solid understanding of the option greeks, including option theta, and how to use them in your trading. Most option traders know there is a time component to options. But surprisingly, many do not have a firm grasp of what that really means. Below we will examine option theta so you can feel more confident and make better decisions as an option trader.

What Is Option Theta?

Option theta measures the rate of decline in the value of an option due to time passing. Keeping it simple, for every day that passes theta should decrease the option’s premium by the amount of theta. Like a life insurance policy, for example, options eventually expire. The rate that option premium declines is measured by the current theta. Option theta is not linear but accelerates as expiration approaches. For example, shorter expirations will have larger thetas and longer expirations will have smaller thetas all else being held constant. In addition, theta increases as expiration approaches especially for at-the-money (ATM) options.

Why Is Theta Highest at the Money?

ATM options have the highest amount of time decay, so they also have the highest theta. Out-of-the-money (OTM) options are also composed of all time premium and no intrinsic value (the amount the option is ITM) – just like ATM options but to a lesser degree. In-the money (ITM) options have smaller thetas than ATM options in addition to intrinsic value. As a buyer of options, picking the strike price to minimize time decay can play an integral part as well as giving an option trader an edge versus a larger theta that an ATM option has.

Can Option Theta Be Positive?

Is option theta always a bad thing? Time passing will always decrease option premium keeping all other variables constant. Long options (both calls and puts) have negative theta, so time passing will decrease the premium. To profit on a long option, the trader needs to sell it for more than it was purchased. Theta is considered negative because it will decrease the premium with each day that passes. Short options have positive theta because premium is decreasing, but that is beneficial for a short position. A trader profits if premium is sold and bought back at a lower amount or it expires worthless. Time passing (a.k.a. positive theta) will do its part to decrease short premium as each day passes.

Negative and Positive Theta Examples

Let’s take a look at examples of positive and negative theta and how each is calculated for the option premium. Below is an example of an option chain for a long call position.

Option Theta - long call

The trader bought the 120 call and its current premium is 9.75 with a negative theta of 0.05 (rounded up from 0.04891). Theta is considered negative because it is a long option and, in this case, a long call. Keeping theta constant, although it should continue to increase as time passes and the option moves closer to expiration, the premium will decline due to time passing. If 5 days pass and keeping all other variables constant, theta should decrease the premium by about 0.25 (5 X 0.05) dropping the premium to about 9.50 (9.75 – 0.25). There is negative theta going to work.

For the option chain below, the same strike and expiration were chosen but this time the position is a short call.

Option Theta - short call

So now, the position has positive theta (short call). Time passing is an asset for this position. So, if 10 days pass and once again keeping all other variables constant, the new premium would approximately be 9.20 (9.70 – (10 X 0.05)). The position has benefitted from a 0.50 (or $50 in real terms) drop in premium.

Lastly

There is more to option theta than knowing it is just time decay. Using it effectively and wisely as an option trader can give you a considerable edge. Not understanding the ins and outs of theta can leave you wanting more time, and time is something you can never get back.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

Categories
Option Greeks

Option Gamma and How It Differs from Option Delta

Option Gamma v Delta

Although it will always be debatable which is the most important option greek, many option traders point to option delta. This is understandable, considering most new option traders become acquainted with delta first. However, you cannot dismiss option gamma, which is sometimes referred to as a derivative of a derivative.

Option Delta and Option Gamma

Option delta measures how much the theoretical value of an option will change if the underlying moves up or down by $1. Long calls have positive deltas meaning that if the stock gains value so does the option value all constants being equal. Long puts have negative deltas meaning that if the stock gains value the option value will decrease all constants being equal.

Option gamma is the rate of change of an option’s delta relative to a change in the underlying. In other words, option gamma can determine the degree of delta move. Keeping it simple, for a $1 change in the underlying, delta will change by the amount of gamma. Gamma increases call option deltas when the underlying moves higher and vice versa. Gamma increases put option delta when the underlying moves lower and vice versa.

Delta and Gamma Example

Take a look at the option chain below. The position is a short (or sold) 125 call with a delta of approximately 0.53 (rounded down) and a gamma of approximately 0.02 (rounded down as well).

Option Gamma v Delta

In this example, if a call option is priced at 7.40 and has an option delta of 0.53 and the stock moves higher by $1, the call option should increase in price to 7.93 (7.40 + 0.53). In addition, the new delta of the short call would be 0.55 (0.53 + 0.02) because of the $1 move higher.

Positive and Negative Gamma

When you buy options (calls and puts), you get positive gamma. When you sell options, you get negative gamma. Positive gamma helps your delta both ways. In other words, if you have a position with positive delta and positive gamma and the underlying moves higher, the positive delta will increase and the gains will become incrementally larger. If the underlying moves lower under the same circumstances, the positive delta will decrease so the losses become incrementally smaller based on delta.

Negative gamma, in turn, hurts you both ways. If you have a position with positive delta but negative gamma and the underlying moves higher, the positive delta will decrease and the gains will become incrementally smaller. If the underlying moves lower under the same circumstances, the positive delta will increase so the losses become incrementally larger based on delta.

ATM, ITM and OTM Gamma

Option gamma is usually highest for near-term and at-the-money (ATM) strike prices, and it usually declines if the strike price moves more in-the-money (ITM) or out-of-the-money (OTM). As the stock moves up or down, option gamma drops in value because option delta may be either approaching 1.00 or zero. Because option gamma is based on how option delta moves, it decreases as option delta approaches its limits of either 1.00 or zero.

Finally

Gamma tends to be one of those greeks (along with vega) that confuses option traders the most. If you remember these few facts about gamma, it can really improve your understanding of all the greeks. I like to tell option traders that delta is the rate of speed for the position and gamma is how quickly it gets there.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

Categories
Option Greeks

Option Delta – A Comprehensive Guide for Traders

Option Delta

Option delta is probably the first option greek many option traders learn. When I first heard and learned about the power of options, I was intrigued. Instead of buying shares of stock I could purchase a call for far less money and profit if my outlook is correct? Sign me up! There are other greeks that can affect an option position, but delta is pivotal. Let’s take a look below.

What Is Option Delta?

The explanation I like best is that delta is the rate of change of an option based on the underlying. To keep it simple, for every $1 the underlying moves, the option premium should change by the amount of delta. Essentially there are only four things you can do with options: buy a call, sell a call, buy a put or sell a put. Long calls and short puts have positive deltas and can benefit from a move higher in the underlying. Short calls and long puts have negative deltas and can benefit from a move lower in the underlying. A long call with a positive delta of 0.40 should increase about 0.40 ($40 in real terms) if the underlying moved a dollar higher and vice versa.

Another definition of option delta that many investors will use is the percentage of the option expiring in-the-money (ITM). So, if the option delta is 0.20, you might say that at expiration, the option has an 80% (100 – 20) chance of expiring out-of-the-money (OTM) or worthless. Investors who often sell options will use this as a guide of probability. Some will also say that option delta is having the equivalent number of shares of stock. If a position has a positive 0.60 delta and the stock moves a dollar higher, the option should gain about 0.60 ($60 in real terms). This is like owning 60 shares of stock with that same move of a dollar higher.

Benefits of Option Delta

As mentioned above, options can be significantly cheaper than buying the underlying outright. By using option delta as your guide, you can gauge your expected profit or loss based on the size of your delta, which you can determine. This is done by buying or selling different strikes and different contract sizes as well. Of course, the bigger the desired delta the bigger the risk. But it will still be significantly less than, say, owning shares of stock. Does this mean that playing the delta is a foolproof way to analyze an option? No. There are other important pricing factors that affect the value of an option. Time (theta), volatility (vega) and more also play important roles. Delta is just one of the greeks traders should take into account when looking for the right option to purchase.

Option Delta Example

Let’s say you have a bearish bias on a stock and you think it will move lower over the next couple of weeks. With the stock trading just above $58 a share, the option trader decides he does not want to risk more than $250 on his position. Looking at the option chart below, he decides to buy the 55-strike put with 37 days to go to expiration.

Option Delta

Since the option position is a long put, the delta is a negative 0.34 (rounded up from 0.3376). So, what does that mean? If the stock moves a dollar lower based on current delta solely, the option premium should increase by about 0.34 ($34 in real terms). The option trader has a negative delta and a negative move in the stock, which would increase the put premium. If the stock moved $2 higher, the put option would lose a value of 0.68 (2 X 0.34) ($68 in real terms) based on delta alone. This is a simplistic but fairly accurate example of what to expect based on delta and the movement of the stock.

Last Words

There is so much more to understanding option delta and options in general than these few points and examples. But understanding and applying them can help your option trading immensely. Delta is just one of the greeks that can affect your option position, but for some trades it can be the most important.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

Categories
Option Greeks

Your Option Greeks Quick Reference Guide

Knowing and understanding the option greeks is pivotal for your potential or continued success as an option trader. Listed below are some of the finer points of delta, gamma, theta and vega. Realistically, each could have its own book explaining how it works and its ramifications, but in this options greeks quick reference guide we will present an overview to get you acquainted. Let’s start with probably the most famous of all the option greeks and that is delta.

Option Delta

There are several definitions of option delta, but the one I like best is that it measures how much the option price should change based on a $1 move. For every dollar the underlying moves higher or lower, the premium should change by that amount. Long calls and short puts have positive deltas. This means the position can profit if the stock moves higher based on delta. Keeping it simple, a long call (positive delta) can profit if the stock moves higher because the right to buy the stock becomes more valuable. A short put (also positive delta) becomes less valuable with a move higher allowing the trader to potentially buy back the put for less. Short calls and long puts have negative deltas. The position can profit if the stock moves lower based on delta.

Option Delta Example

Take a look at the screenshot below and notice the position is a short call with a negative delta of approximately 0.51.

If the underlying moved $1 higher, the premium would increase about $0.51 ($51 in real terms). The option trader sold the call, so he would have to spend $51 more if he wanted to buy back or close the position. A $1 move lower would have decreased the premium by $0.51 (again $51 in real terms), which would be beneficial for the short position.

Option Gamma

Gamma can be daunting for option traders, but it doesn’t need to be. Option gamma measures how much delta should change based on a $1 move. Keeping it simple once again, gamma changes the delta based on a dollar move higher or lower. Negative or positive gamma confuses many option traders, but it is fairly simple to understand. Long options (both calls and puts) have positive gamma, and short options have negative gamma. Positive gamma increases the delta when the stock moves in the intended direction and lowers the delta when the stock moves against you. Negative gamma increases the delta when the stock moves against the position and decreases the delta when the stock moves in the intended direction.

Option Gamma Example

Take a look at the screenshot below and notice the position is a long put with a positive gamma of approximately 0.05.

If the underlying moved $1 lower, gamma would increase the negative delta (because it is a long put) by about 0.05 to approximately negative 0.70 (0.65 + 0.05). The more the underlying continues to fall, the greater the potential gains. A $1 move higher would do the opposite to the negative delta. It would decrease the negative delta to approximately 0.60 (0.65 – 0.05).

Option Theta

Theta is usually one of the easier greeks for option traders to understand. Option theta measures how much the option price will decline due to the passage of time. For every day that passes, the option price should decrease by the theta amount. Long options, both calls and puts, have negative theta. Short options, both calls and puts, have positive theta. The thing to remember is that options are always losing value due to time. If an option has positive theta, the passing of time benefits the position. If the position has negative theta, time passing hurts the position.

Option Theta Example

Take a look at the screenshot below and notice the position is a long call with a negative theta of approximately 0.16.

When one day passes, the premium would decrease about $0.16 ($16 in real terms) to about 11.84 (12 – 0.16). The option trader owns the call, so he would lose about $16 if he wanted to sell the call option and close the position. If a call or put had been sold, time passing would have still lowered the premium; but this would have been beneficial for a short position because of the reduced premium (cheaper to buy back).

Option Vega

Vega can be a bit daunting like gamma for option traders, but it does not need to be. Option vega measures how much the option price will change due to changes in implied volatility (IV). For every 1% change in IV, the option price should change by the amount of vega. Like gamma, long options, both calls and puts, are said to have positive vega. An increase in IV will benefit the position and vice versa. Short options, both calls and puts, are said to have negative vega. A decrease in IV will benefit the position and vice versa.

Option Vega Example

Take a look at the screenshot below and notice the position is a short put with a negative vega of approximately 0.04.

If IV moved 1% lower, vega would decrease the premium (because it is a short put) by about $0.04 ($4 in real terms) to approximately 3.66 (3.70 + 0.04). A 1% move higher in IV would do the opposite to the option premium. It would increase the premium to approximately 3.74 (3.70 – 0.04).

Wrapping This Up

I hope this brief explanation of the option greeks will serve as a general overview that helps you throughout your option trading career, especially at the beginning. Understanding the greeks is essential to becoming a better and more knowledgeable option trader.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.