Veteran traders rely on benchmark options concepts to point them in a certain direction. Explore popular advanced concepts and how to apply them to your trading.
It’s all about the Greeks
Perhaps most essential to options traders is the necessary understanding of “the Greeks”. In a nutshell, Greeks as they relate to options trading, are defined as different types of risks—such as time, volatility, and price changes—associated with various positions, each one represented by a certain letter in the Greek alphabet. The most commonly used are delta, gamma, theta, and vega. Rho is another that is used less often.
This represents a theoretical estimate of how much an option’s premium might change based on a $1 move in the underlying security. For example, a delta of .50 denotes an expected 50 cent move in the options premium with a $1 move of the underlying security in either direction. When there is a slight delta variation depending on price direction, that’s considered an up delta or down delta.
Why is delta important?
Simply put, delta is a metric that can help experienced traders measure the impact of a change in the price of the underlying security. Delta tends to increase as you get closer to expiration for near or at-the-money options, and may change depending on implied volatility.
The option’s gamma is a measure of the rate of change of its delta. The gamma of an option is expressed as a percentage and reflects the change in the delta in response to a $1 movement of the underlying stock price.
Why is gamma important?
Gamma is a risk measurement that’s often most useful to traders with fairly large positions, but learning it can help you better understand how options behave. You can use gamma to anticipate the change in delta, and to see how rapidly delta can change as expiration draws closer, emphasizing the need for close monitoring of positions.
Theta is a way to measure the impact and exposure of the passage of time on an option’s price. In theory, theta represents how much an option’s premium may decay per day or week with all other market factors and variables remaining the same.
Why is theta important?
Time decay is an important concept in options trading, and theta is one metric that can be used to quantify this, so that you can make more informed choices in constructing strategies, especially with short-term, at-the-money options, which usually have high theta values. Theta is generally expressed as a negative number, and reflects the amount by which the option’s value will decrease every day.
Traders use vega to measure the impact of changes in the underlying volatility to the price of an options contract. More specifically, vega represent a change in an option’s theoretical price that correlates to a one percent change in its volatility.
Why is vega important?
Volatility can have a major impact on your options trade, so vega is an important Greek for assessing your risk-reward profile for any given trading or strategy you’re considering. Because vega represents underlying volatility, it can also have a major impact on how traders perceive options to be appropriated valued, relative to their price.
Rho is a value intended to measure an option contract’s sensitivity to interest rate changes. It is a way to assess the potential change in an option’s value given a change in interest rates. Rho and interest rate changes have the strongest impact on longer-term options.
Why is rho important?
Relative to delta, vega, gamma, and theta, most traders agree that rho has less of a measurable impact on option prices overall. Still, it is another metric that can be used to help understand how options are influenced by interest rates, and may have some bearing on longer-term options positions.
Volatility: An essential factor in options trading
Simply put, in options trading, volatility measures the rate and magnitude of pricing changes in the underlying security, such as a stock or ETF. There are two types of volatility: historical volatility (or statistical volatility) and implied volatility.
Historical volatility is the actual volatility of a financial instrument over a given time, usually determined by the average deviation from the average price during that period. Implied volatility is exactly as it sounds—it is the inferred, or implied, volatility of a security’s price.
When historical volatility and implied volatility are compared against each other, it can be a useful tool for traders to estimate the future fluctuations of a security’s worth, based on certain factors and predictions. But the most practical benefit of analyzing volatility in options trading is the insight it can give you in terms of valuation.
Using volatility in options trading
Market volatility, whether high or low, can be used in options trading to seize opportunities. For example, a few high volatility options strategies that may be beneficial when there are large, significant moves in stock prices could include:
- Debit put spreads: Buying one put and selling another put with a lower strike price for a limited risk strategy that offers partial protection to the downside, with limited risk to implied volatility changes.
- Collars: Buying a downside out-of-the-money put and selling an upside out-of-the-money call for a limited risk strategy, and complete downside protection at the long put strike.
- Put spread collars: Buying a debit put spread and selling an upside out-of-the-money call for a limited risk strategy offering partial protection to the downside.
Theoreticals: Assessing options value using models
Just as equity traders use analytical tools and fundamental indicators to help them try and assess a stock’s value versus its current price, experienced traders use theoretical pricing models to achieve the same with options. These models are theoretical, and are based on inputs such as any of the Greeks, underlying price, strike, days until expirations, and other factors that often change frequently, many times during a single trading session.
Popular among professional traders and investors, theoretical models, such as Black-Scholes, are designed to help monitor changing risks, and accurately assess the value of options positions on an ongoing basis.