Papale on Theoreticals and Greeks

When we first bought our dog many years ago he needed to be trained not to nip.  Once in a  while she would snap at a cousin or friend and immediately I gave her a gentle but firm whack on the nose.  She learned quickly that biting would not be tolerated.  Maybe that’s what the Uruguay soccer player Luis Suarez needs.  One big whack on the nose.

The greeks.  Everyone’s favorite topic of conversation.  For option traders understanding the greeks are critical to understanding our trades.  Delta, gamma, theta and vega describe different risk and performance factors in an option trade.  A couple things are helpful to review from time to time.

First, greeks are theoretical.  Option models generate them based on various inputs such as underlying price, volatility, interest rate, strike price and time until expiration.  While most models are pretty much the same these days, there might be some difference in the greeks between one model and the other.  For example, some models use flat line volatility skews which assumes the same volatility across all strikes.  Hence that is the IV put into the model to generate the greeks at each strike.

Others, like OptionVue, use a skewed vol curve which is a bit more accurate in assigning volatility for each strike.  This difference in volatility input could cause slight differences in all the greeks.  Since greeks are theoretical, it is often difficult to observe them in the market place.

For example, theta might be $100 per day.  While the option theoretically will decay by $100 each day, the price of the option is determined by theta, change in the underlying and changes in implied volatility.  So the price may change by more or less than $100.

Remember too that the greeks are a snapshot in time, price of the underlying and implied volatility.  While they are very useful in predicting and evaluating performance, theoretically they change as soon as they are calculated.  In reality though the change will be quite small unless underlying or IV changes dramatically.

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