By: Tom Gentile
on October 25th, 2021
Options are very sensitive derivatives. They are sensitive to the price fluctuations of the underlying stock, as well as to the passage of time and to fluctuations in implied volatility (IV). There are others, but these are the big 3. In other words, if you buy an option, its value will change as the stock moves, as time passes and as IV fluctuates. These sensitivities are called “The Greeks.”
What Are The Greeks?
These terms may seem intimidating to new option traders, but they’re easy to break down and refer to simple concepts that can help you better understand the risk and potential reward of an option position.
- Delta indicates how much your option position will change in value with a $1 increase in the underlying stock.
- Theta measures how much your option position will change in value with the passage of 1 day of time.
- Vega shows how much your position will change in value with a 1% increase in IV.
Think of The Greeks as your dashboard. Just like for your car, this option dashboard will help you anticipate how well your option position will perform.
An Example of The Greeks
Here’s an example of a long call option on the Select SPDR S&P 500 ETF (NYSE: SPY).
The Delta is 42.52. A $1 increase in the underlying stock will increase the position’s value by $42.52. (Note: there is no “$” because Delta is also an indication of the position’s equivalent number of shares of underlying stock AND the probability the option will expire In-The-Money (ITM)).
The Vega is $26.93. A 1% increase in IV will add $26.93 of value into the position.
The Theta is -$23.24. Holding this call option 1 day will reduce the positions value by $23.24.
So, all of this is certainly more complicated than buying shares of stock. There are more moving parts. More moving parts = more opportunity to lose money. It also equals more opportunity to MAKE MONEY… if you understand the Greeks.
Now, don’t worry. All of my systems take The Greeks into account and if you follow my rules-based approach, you’re handling The Greeks.
How to Approach The Greeks
The way to turn the sophistication of the options pricing model on your side is to develop a 3-part prognosis:
- Direction — Up, down or sideways
- Time — How much time your prognosis is good for
- Implied Volatility (IV) — Will IV rise or fall
I have many systems for picking direction. Alpha 9, Money Calendar, and Surge Strike are just a few of them. Directional systems often come with a price or profit target. There are bullish directional systems, bearish and non-directional (sideways). Delta measures your positions sensitivity to a $1 move up in the underlying stock. A positive Delta means you have a bullish position, a negative Delta means that you have a bearish position.
Stocks bounce around. You may have a long-term prognosis that stock XYZ may double. You may have a short-term prognosis that stock XYZ may go sideways or maybe even NOT go up (I’ll cover this high probability options strategy in a later article). Time is the chihuahua nipping at the heels of a long option trade (call or put). As time passes, the option’s value erodes. Theta measures the amount of time decay your position will experience each day.
Implied Volatility (IV)
IV is the least understood component of an option’s value. The few that understand it, profit from it. The rest often lose from it. There are a few ways to develop an IV prognosis, but the simplest and most consistent is that IV generally falls when a stock rises and rises when a stock falls.
Once you have a prognosis in each area, it’s a simple matter to line up The Greeks with your prognosis.
Here’s a breakdown of prognosis’ and the desired Greek.
Time is a different beast. Theta will always be negative if you buy an option. Time is always working against long option positions and Theta tells you how much you will lose each day and serves mostly as a warning system. Theta gets more negative as the option expiration date approaches. To make money on an option, Delta and/or Vega must offset Theta.
Don’t worry, my systems routinely churn out trades that dramatically offset Theta.
Before I leave Theta, what if I were to tell you that you can construct option positions with a POSITIVE Theta? Meaning that as time happens, you’re option position is cashing in. That’s right, the sun rising generates profits in your trade. Now that’s a 100% proposition.
With the basics established, I’ll be diving into a lot more detail on the Greeks, including Theta Positive trades, so be sure to stay tuned!
Recapping The Greeks
The key takeaway is that Delta, Theta, and Vega are known as the “Greeks,” and provide a way to measure the sensitivity of an option’s price to various factors. Together, the Greeks let you understand the risk exposures related to an option.