Using ‘The Greeks’ in Options Trading–Part I

July 21, 2009 by  
Filed under Options Trading

Modern mathematics practices praise the ancient Greeks for inventing elementary calculations still used today. However, modern mathematic tools have helped to assess risk and calculate prices and profits for the many new investors embarking on the world of options trading. These tools include delta, theta, gamma and vega, commonly referred to as ‘The Greeks’.

Luckily, we don’t need to understand all of the underlying calculations to use these tools and further use the basic concepts needed to measure risk and maximize profits.

Factors that affect the price of an option in the market are quantified as The Greeks in the world of options trading. These factors may include the asset’s market price, the strike price, the expiration date, and current volatility and short-term interest rates. Common sense may tell you how these indicators and values may affect the value of an option you’re considering trading.

Let’s first consider the strike price. This is the specified price that the asset, which may be a stock, bond or real property, must be traded at if the option is ‘exercised’.

For example, if Microsoft was priced at $28 per share and the option was a June 32 call (this 32 is the strike price, not a date typo), this option would be referred to as ‘out-of-the-money’ since the market share price is lower than the strike price.

Depending upon how big this difference between the two is, the price of the option will be affected to some degree. ‘Delta’ is a measurement of this difference.

Using complicated calculations that employ ratios comparing the change in the asset price and the change in the option price, delta is calculated and expressed. If delta is 0.7, this means that with every $1 rise in Microsoft, the option would be expected to rise $0.70.

Any online option trading software should calculate and provide all the Greek calculations for you, as well as the price of the option and expiration date. As the option reaches its expiration date, delta tends to increase, especially for options that are near to in-the-money. Volatility also contributes to changes in delta, and should also be expressed on your trading software tools.

The ‘time decay’ of an option is measured by theta; this means that it measures risk and value when considering the time left before arriving at the expiration date and the likelihood that that the market share price will rise or fall, whichever is desired.

If the example June 32 call had a premium of $3 and theta was expressed as 0.5, this tells you that the value of the option will likely drop 50 cents per day prior to expiration. As this expiration comes nearer, the premium of the option is also expected to decline at a faster rate.

Theta will always reflect these changes, and once an option is purchased, the Greek indicators should be closely watched. As with any investment, it is suggested to study and be completely prepared for the volatile changes experienced when trading options.