Using ‘The Greeks’ in Options Trading–Part II

July 23, 2009 by  
Filed under Options Trading

If you read Part I, you are slightly familiar with using the Greeks as indicators when trading options, and how delta and theta can be used. Here, we’ll take a look at gamma and vega.

Gamma is calculated via complicated mathematics, but is based on a simple idea. It reflects the rate of change of delta, compared to the changes in price of the underlying asset. This tool helps to estimate the price of an option and how far it’s in or out of the money.

Gamma is small when an option is far in or out of the money. At its maximum, it indicates the option price has approached ‘at-the-money’ levels.

Vega reflects the option’s price and its sensitivity to changes in volatility. This is essentially the degree of which and how frequently the price of the asset changes. Sharp decreases or increase in price are considered high volatility.

There are also several kinds of volatility, including implied volatility. This is arrived at by considering the exercise price, rate of return, expiration date and premium price. Your online options trading software may also offer historical volatility measurements.

These calculations are very complex, but as an investor you only need to understand the basic underlying ideas. Increased volatility will give you a clue to increased risk, because this measurement reflects the amount of uncertainty and your possible gain or loss on the option.

When prices change slowly, you’ll have more time to react properly. Very little is lost or gained when price changes are very small. Large changes in price in a short amount of time means your option is highly volatile and you have a risk of losing everything.

This is where vega comes in to play. Vega can be used to assess the current volatility and use this information to make your next move. When the asset experiences increased volatility, the price of the option will tend to increase. However, different options will react differently and have individual vega measurements.

Even though all of the Greeks are extremely helpful in trying to manage risk and make educated options trading decisions, these calculations should be only considered to be tools in your practice as an investor. They do not indicate a sure-fire win if certain measurements occur, but rather serve as an indicator that the likelihood of winning in this circumstance is more likely.

Several online options trading software programs will automatically calculate and provide these measurements as needed with a standard membership package. Make sure you understand the option trading process thoroughly before beginning to trade in order to reduce your risk, and start as small as possible.

Practicing several mock trades before using actual money will help you to determine the usefulness and your understanding of the Greeks when assessing options and their associated risks. Also seek out online forums, books and any other resources available to gain a deeper understanding of option trading. Much of it may seem confusing at first, but over time you’ll find it will become easier.