Understanding Option Greeks

Trading options can be a very risky investment strategy if you do not know how to full evaluate your potential candidates. If you are trading options without an understanding of the Greeks, then you are exposing yourself to big risks. It has been said that trading options without knowledge of the Greek indicators is like flying a plane without ever taking a lesson. Well this article is here to help you have a basic understanding of the Greeks and how you can use them to find profitable option trades.
When you trade options you have to deal with price changes, volatility changes and time decay which could be against you or work for you. For instance, if you buy a put or call, you are at risk if the underlying price moves the opposite way, falling implied volatility (IV) and time decay. If you sold a put or call, your risks would be again prices moving against, you, rising implied volatility but time decay works in your favor.

Having an idea if your position is exposed to one of these risks is essential so that you may protect yourself from losses. That is where the three basic Greeks come in: Delta, Vega, Theta. Every option and option spread has their own Greek values that should match with the underlying market trend to give your strategy a better chance.

Delta: One of the more popular Greeks, Delta measures the option’s sensitivity to changes in the underlying asset’s price. As an example, let’s use IBM ($110.09) January call strikes: January 100 Call has Delta of 90.2, 110 Call is at 52.9, 125 Call is at 2.27. From this, you can see that the in-the-money call, the 100 Strike, had the highest Delta while the out-of-the-money 125 Call was the lowest.

One way traders interpret these Delta figures is as a probability percentage. For example, the 100 Call has a 90.2% chance of expiring in the money. The 110 Call has a 52.9% chance, the 125 a 2.27% chance. However, this assumption is based on the fact that the underlying security is not in a major trend.

Vega: This Greek measures the risks involved with gains or losses that come from changes in volatility. As an example, we turn again to our January IBM (underlying price still $110.09) Calls. The January 110 has Vega of 3.01, 105 strike is at 1.27 and 100 is at 0.49. As you can see, as the strikes go farther out-of-the-money, the Vega number is higher. This means that the father out-of-the-money strikes are at a higher risk when volatility falls.

The same is true for father out months. The 110 strike Call has higher Vega premiums as time goes farther out. This is why LEAP options carry high risks of falling due to volatility changes. However, they can also be very profitable. The bottom line is the Vega is used to determine your risk to changing volatility.

: This Greek measures the rate at which time decay is decaying. Theta is always negative because time decay is always decaying until the option finally expires. It is essential that you know what your Theta is before you trade because you could be putting yourself against the odds. If the January 110 Calls have a Theta of -7.58, that means it is losing $7.58 in time value every day. As expiration nears, the rate of decay increases. That is why farther out months have a slower rate of decay but that means you are facing premium risks from Delta and Vega. Ultimately, you must decide between rapid decay risk or volatility risk. This decision can be made based on your forecast for your trade. If you expecting a quick, rapid rise in the underlying price; buy closer months. If you are taking a longer term approach a LEAPs strategy may fit you.

The bottom line is that you have a basic understanding of the most essential Greeks. I advise you to do outside research to go more in depth in option Greeks before you begin trading. As you can see, understanding these indicators can mean profits or losses. Once you have these down, you will be able to detect low risk, higher reward scenarios in the options market.

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About Matt Rego

Matt has been trading for many years and is an experienced financial author. His main focus is the Forex market. Visit Matt on Google+.