By Steve Papale
With the 2016 election season in full swing, it is clear we are venturing into strange new worlds when it comes to basic civility in campaigning. I’m no politician or political observer, and politics has always been an event not for the faint of heart or sensitive, but this year watching debates or campaign sound bites is more like an episode of Jerry Springer than dialog of potential candidates to lead and represent our country. Not sure where this will all end up but I’m beginning to wonder who can best take and give a punch.
We’ve been going through options boot camp for several weeks and we are finally closer to the end than the beginning. Today, we will touch on a subject that tends to require the most heavy lifting in options education – the greeks. We obviously are not going to get into a detailed exposition on this subject but will introduce them and why they are important.
There are 4 primary greeks – delta, gamma, theta and vega and these are used to measure certain performance criteria of an option position. But before I get into the first, delta today, lets quickly go over why they are important. The performance of options, unlike stock, goes beyond simple movement in the underlying. If I am long 100 shares of IBM, my P and L is strictly a function of the price movement in IBM, nothing more or less (ignoring dividends). Our option P and L are not only affect by movement in the underlying but changes in IV and the passage of time. So measuring these changes is important. Most retail option traders use the greeks in 2 ways. First, when evaluating a position before placing it, the greeks give a nice snapshot of the various risk factors going into the trade. Second, during the trade, greeks help to explain the performance of the P and L. And one other thing. The greeks are a static measure, that is they are snapshot in time, underlying price and IV. Models do well in predicting performance over a range of price and time but technically greeks are in constant flux.
Ok let’s start with the first greek – delta. Delta measure the effect of a change in underlying price on the price of an option. So if IBM moves $1 up or down, what will that do to the price of the option. That effect is measured by delta. For an option with a delta of .50 (at the money) for every $1 move in stock, that option will move $0.50. Options with bigger deltas have greater response to movement in underlying and options with smaller deltas have less effect. Deltas can also be thought of as probability measures. For example, an option with a delta of .10 can be thought of as having a 10% chance of finishing in the money at expiration. These probabilities are useful in certain statistical types of trading. Finally remember from above, the greeks are static. If markets move, deltas change. So when the stock was at 100 and the delta was .50, the delta will be different if the stock is 120. Next week: gamma, theta and vega.