Springtime is upon us—a time for new beginnings, and new seasons. Like baseball, for instance, and earnings. Are you among those considering options strategies this season? After all, earnings “surprises” can be positive or negative, and a stock’s reaction can be moderate or extreme.
Options aren’t suitable for everyone but they are often used by sophisticated investors looking for a way to use leverage to speculate on direction, as well as volatility, during earnings season. Options are also used to help protect a portfolio against adverse moves in the portfolio itself or its components.
Do you find yourself in need of some options education, or perhaps a refresher? If so, we’d like to suggest a foreign language—Greeks—the unofficial language of options. Understanding options terminology can help you understand how options prices move, and how to assess potential risks on options positions, during earnings season, or any season.
There are three major variables that affect the price of an option: changes in the price of underlying, changes in implied volatility, and the passage of time. Interest rates and dividends also play a part, but generally to a lesser extent, in that changes occur less frequently. The sensitivity of options prices to changes in these variables are known collectively as “Greeks.”
Delta and gamma relate to changes in the price of underlying. Theta measures the effects of time. Vega (and yes, we know “vega” is not a letter in the Greek alphabet), deals with changes to implied volatility. And as you can imagine, vega is particularly important during earnings season. So let the lesson begin.
But one caveat before we get started. These measurements are, in general, theoretical, based on an option pricing model such as the Black-Scholes model. There’s no guarantee that, in the real world, an option’s price will move in lockstep with the theoretical changes predicted by a model.
Delta and Gamma – Change in the Underlying
An option’s price typically changes when then the price of the underlying changes. Delta says by how much. It’s defined as an option's sensitivity to changes in the price of the underlying. The option is going to move at some percentage (100% or less) of what the underlying does. So if an option has a 50 delta—which might be expressed as .50 because it’s a percentage—and the underlying moves by $1, then the option should move by 50 cents.
Call options have positive deltas since calls typically increase in value when the underlying moves higher. Puts, on the other hand, have negative deltas since put prices typically move in the opposite direction of the underlying. But don’t worry; you needn’t be an expert on the math behind the pricing formula to calculate any of this. If you’re a TD Ameritrade client, it’s all there for you on the thinkorswim® platform from TD Ameritrade, as shown in figure 1.
As the underlying moves, however, an option’s delta doesn’t remain constant. It changes. Gamma says by how much. It’s expressed as delta's sensitivity to a $1 change in the price of the underlying.
Here’s a quick example of delta and gamma. Let’s say a call has a .39 delta, and .06 gamma. If the underlying were to rise by $1 the call value should rise by its delta, about $0.39. But the delta would also rise, to about .45 (its original delta of .39, plus its gamma of .06). So if the underlying were to rise another $1, the call value should rise by about $0.45.
Delta and gamma work the same way on a $1 drop in the underlying—if a .39-delta call has a gamma of .06, a $1 drop in the underlying would lower its theoretical value by $0.39, and its delta would drop to .33.
Understanding delta and gamma can play a big part in both directional and non-directional trading strategies.
Theta – Change in the Time until Expiration
One thing that’s constant is time, and options tend to lose value over time. Theta says by how much. This greek, also known as “time decay” or simply “decay,” is defined as a measure of an option's sensitivity to time decay. So if a call option is worth $1.50 today and it has a of theta of .10, then tomorrow—all other things being equal—it will be worth $1.40.
If you owned one of these calls, theta would cost you $10 per option ($.10 times the contract multiplier of 100) to hold the position overnight. If you owned ten, it would cost you $100 per day. The person who is short 10 calls, all else equal, would have a theoretical profit of $100. Time decay is the heart of strategies such as iron condors, calendar spreads and butterflies.
Vega – Change in the Implied Volatility
A key determinant of option prices is implied volatility (IV). That’s the market’s best guess for how much price variability is expected in the underlying, based on current prices of options trading in the marketplace. If the IV goes up, option prices tend to go up. If IV goes down, option prices tend to go down. Vega says by how much, and it’s expressed as a measure of an option's sensitivity to a 1% change in the underlying’s IV.
Let’s say that the call that’s worth $1.50 today has a 30% implied volatility and a vega of $0.05. If the implied volatility drops to 28%, the option will lose $0.10 of value ($10 for one option). The option would gain $0.15 if the implied volatility rose 3% to 33%.
Straddles and strangles are among the strategies that give traders the ability to speculate or hedge against changes in implied volatility.
Understanding the Greeks can be a critical step in understanding the potential risks and rewards of options trading.
Want more? Join Swim Lessons on April 26, 2017 at 10:30 AM CT as Scott Connor and I dive into Greeks and how you can use them to evaluate options strategies, risks and potential rewards, during earnings season, and the rest of the trading year.
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