Trading options give you a ton of flexibility. You can use them to speculate, hedge, generate income, buy stocks for less, and make best on volatility.
That said, they offer great leverage and the ability to put strategies with defined risk right to work.
And oh yeah… you can make some pretty mean returns once you get the hang of trading them.
Now, when you are trading stocks, your P&L is dependent solely on the changes in the stock price. For example, if you buy shares and the stock price rises, you make money. On the other hand, if prices dip, you lose money. Very simple.
Options are slightly more complicated than that. There are more factors involved that influence its pricing. These include the risk-free interest rate, cost of carry, time to expiration, volatility, the strike price, and movements in the underlying stock price.
To help understand the risks involved option traders will use something called Option Greeks.
Let’s take a look at some of these Option Greeks and what they’re all about.
Delta: This measures the rate at which the price of an option changes relative to the price changes in the stock.
Example: On May 26, 2017, the SPDR S&P 500 ETF closed at $241.71.
The delta of the $241.5 calls expiring on June 2, is 0.56
In other words, if the stock prices move up $1, and everything else stays equal, the value of the option contract will increase by $0.56.
Call options have a delta of zero to one.
Call options that are out-of-the-money usually have delta’s below 0.50
Call options that are in-the-money usually have delta’s higher above 0.50
Call options that are at-the-money usually have a delta around 0.50
On the other hand, puts will have negative delta’s with -1 being the lowest level.
Think of it this way, the $241.5 calls are like being long 56 shares of stock. And the $241.5 puts are like being short 44 shares of stock. One option contract leverages 100 shares of stock. That said, the higher the delta, the more the option value will move like the stock.
Gamma: This measures the rate at which the delta will change relative to a point change in the stock.
Example: On May 26, 2017, the SPDR S&P 500 ETF closed at $241.71. The gamma of the $241.50 calls is $0.26
In other words, if the stock prices move up $1, and everything else stays equal, the value of the delta will go from 0.56 to 0.82. On the other end, if the stock price drops a point, the delta will change from 0.56 to 0.30.
Gamma is highest for options that are at-the-money.
Gamma can be very sensitive with options nearing expiration.
Theta: This measures the amount of daily time decay that occurs from holding the options.
Example: On May 26, 2017, the SPDR S&P 500 ETF closed at $241.71. The theta for $241.5 calls is -0.07
In other words, the value of these calls will lose $0.07 from time decay. However, theta is not constant. In fact, it accelerates as we approach expiration.
For example, if you keep everything else constant, with one day to expiration, the theta increases to $0.12.
Option premiums consist of intrinsic value and time value. That said, at expiration, you’re only left with intrinsic value. Hence, the reason why theta increases as we approach expiration.
At-the-money and out-of-the-money options tend to have the most time value and theta decay. The deeper in-the-money an option is, the higher the delta, the less influence theta has on the option value.
Vega: This is the sensitivity an option’s price has to a one-point change in implied volatility.
Example: On May 26, 2017, the SPDR S&P 500 ETF closed at $241.71. The implied volatility on the $241.5 calls is 8.22% and the vega is $0.27.
That said, if implied volatility were to jump 4 points, the value of those calls would increase by $1.08.
If you think about it, that’s really powerful. If the SPY were to increase 1 point you make just $0.52 on a long call. However, a large spike in implied volatility can have a huge impact on your P&L.
Moreover, it’s important to pay attention if volatility is relatively cheap, expensive, or fairly priced. You want to be a buyer of options when they are cheap and a seller of them when they are expensive.
Some newbie option traders allow this to trip them up. However, you can find volatility rankers on most broker platforms these days.
For example, over the last 52 weeks, the implied volatility mean of the SPDR S&P 500 ETF Trust has been in a range between 7.6 and 20.9. That said, if it’s currently at 8.09, it’s safe to say SPY options are relatively cheap.
Pricing an option includes the risk-free interest rate, cost of carry, time to expiration, volatility, the strike price, and movements in the underlying stock price.
The Option Greeks tell us how much the value an option will change depending on these factors.
Of course, the more advanced you get with options the more flexible you can be. For example, spread trading allows you to decrease the role that volatility and time decay have.
Furthermore, you can put on strategies like buying deep “in-the-money” options, whose values are more dependent on how the stock moves. Or you could buy deep “out-of-the-money” options with the goal of profiting off a volatility spike.
That’s the beauty of options, you express your opinion in several different ways.
Jason Bond runs JasonBondPicks.com and is a swing trader of small-cap stocks.