Option Greeks: Introduction
Published originally at Investopedia.com
By John Summa, CTA, PhD, Founder of OptionsNerd.com
Trading options without an understanding of the Greeks – the essential risk measures and profit/loss guideposts in options trading strategies – is synonymous to flying a plane without the ability to read instruments.
Unfortunately, many traders are not option strategy “instrument rated”; that is, they do not know how to read the Greeks when trading. This puts them at risk of a fatal error, much like a pilot would experience flying in bad weather without the benefit of a panel of instruments at his or her disposal.
This tutorial is aimed at getting you instrument rated in options trading, to continue the analogy with piloting, so that you can handle any strategy scenario and take the appropriate action to avoid losses or enhance gains. It will also provide you with the tools necessary to determine the risk and reward potential before lift off.
When taking an option position or setting up an options strategy, there will be risk and potential reward from the following areas:
- Price change
- Changes in volatility
- Time value decay
If you are an option buyer, then risk resides in a wrong-way price move, a fall in implied volatility (IV) and decline in value on the option due to passage of time. A seller of that option, on the other hand, faces risk with a wrong-way price move in the opposite direction or a rise in IV, but not from time value decay. (For background reading, see Reducing Risk With Options.)
Interest rates, while used in option pricing models, generally don’t play a role in typical strategy designs and outcomes, so they will remain left out of the discussion at this point. In the next part of this tutorial, the role interest rates play in option valuation will be touched on in order to complete the overview of the Greeks.
When any strategy is constructed, there are associated Delta, Vega and Theta positions, as well as other position Greeks.
When options are traded outright, or are combined, we can calculate position Greeks (or net Greeks value) so that we can know how much risk and potential reward resides in the strategy, whether it is a long put or call, or a complex strategy like a strangle, butterfly spread or ratio spread, among many others.
Typically, you should try to match your outlook on a market to the position Greeks in a strategy so that if your outlook is correct you capitalize on favorable changes in the strategy at every level of the Greeks. That is why knowing what the Greeks are telling you is so important.
Greeks can be incorporated into strategy design at a precise level using mathematical modeling and sophisticated software. But at a more basic level, the Greeks can be used as guideposts for where the risks and rewards can generally be found.
A simple example will help to demonstrate how not knowing the Greeks can lead to making bad choices when establishing options positions.
If you open any basic options book for beginners, you’ll typically find a calendar spread as an off-the-shelf, plain vanilla approach. If you have a neutral outlook on a stock or futures market, the calendar spread can be a good choice for strategists.
However, hidden in the calendar spread is a volatility risk dimension rarely highlighted in beginner books. If you sell an at-the-money front month option and buy an at-the-money back month option (standard calendar spread), the Vega values on these options will net out a positive position Vega (long volatility).
That means that if implied volatility falls, you will experience a loss, assuming other things remain the same. What you will find is that a small change in implied volatility (either up or down) can lead to unrealized gains or losses, respectively, that make the potential profit from the original differential time value decay on the calendar spread seem trivial.
Most beginner books regarding calendar spreads only draw your attention to the position Theta; this example demonstrates the importance of a combination of Greeks in any analysis.
When a pilot sees his or her horizon indicator and correctly interprets it, then it is possible to keep the plane flying level even when flying through clouds or at night. Likewise, watching Vega and other Greeks can help keep options strategists from suffering a sudden dive in equity resulting from not knowing where they are in relation to the risk horizons in options trading – a dive that they may not be able to pull out of before it is too late.