Getting to Know the Lesser-Known Greeks

• Posted by Andrea Kramer
• on July 6th, 2011

Most seasoned option speculators are familiar with delta, which is the percentage of the price movement in the underlying stock that will translate into the price movement in a particular option. Or, simply put, an option’s delta indicates the amount the option will gain for every dollar increase or decrease in the stock price.

In this article, however, we’ll take an odyssey through some of the lesser-known Greeks, including gamma, theta, and vega (Get it? Odyssey? Homer? Greeks? We crack ourselves up!).

Gamma is always positive on both calls and puts if you are long (the buyer) option premium. Conversely, the gamma of both calls and puts is always negative if you are short (the seller) option premium.

Positive gamma implies that the delta of a long call will move closer to +1 when the share price rises, and will inch closer to 0 when the stock falls. On the flip side, positive gamma indicates that the delta of a long put will become move closer to -1 when the stock price falls, and creep closer to 0 when the stock price rises. The opposite is true for short gamma.

Simply put, a position with positive gamma will typically produce deltas that benefit from a stock’s movement on the charts. On the other hand, an option with negative gamma tends to generate deltas that may decrease your profit potential as the underlying security ticks higher or lower.

Gamma is highest for options that are at the money, since the delta of these contracts fluctuates the most as the stock price changes. Furthermore, the gamma of an at-the-money option increases with lower volatility from the underlying stock, or as options expiration draws near.

As options expiration approaches, the price of an out-of-the-money option will decrease at a rapid pace, as the chances for the position to finish in the money diminish. Heading into expiration, the rate at which an option’s premium decays per unit of time is called theta. In other words, theta approximates how much the value of an option decreases for every day that passes without volatility in the underlying stock price.

Opposite of gamma, long calls and puts always have negative theta, while short calls and puts always have positive theta. At-the-money options will have the highest theta, as they have the highest extrinsic value, while the theta of in-the-money and out-of-the-money options will fizzle as expiration nears.

Which brings me to my next point: options with little time left until expiration will hold less extrinsic value than a further-dated option, indicating that theta affects front-month options more than back-month options.

For example, let’s say Stock XYZ is trading near the 55 level. Our friend John owns an XYZ August 50 put, while Jane owns an XYZ November 50 put. John’s option is currently worth $2, and has a theta of -.20. Meanwhile, Jane’s option – which has more time until expiration – is currently worth $5, and has a theta of -.05.

Now, let’s fast-forward one session. The shares of XYZ are still at 55, and the implied volatilities of both options have remained the same. In this case, the theta of the August 50 put will decline by 20 cents (its theta) to $1.80, while the November 50 put will fall by only 5 cents (its theta) to $4.95. Though both the August and November-dated puts have the same strike, the theta was smaller in the longer-term option, as it has more time until expiration.

Finally, vega estimates how much an option price will fluctuate in parity with an increase or decrease in implied volatility. Both long calls and puts have positive vega, while short calls and puts have negative vega. In other words, option buyers prosper from higher implied volatility, as a more volatile stock has a greater chance of finishing in the money by expiration.

For instance, the premium of a call with a vega of +.40 will increase by 40 cents for every 1% the implied volatility rises. Conversely, a call with a vega of -.40 will lose 40 cents for every 1% rise in the implied volatility.

For example, let’s say that Sally has also had her eye on Stock XYZ, and purchases an XYZ October 50 call. The option is currently valued at $4, has a vega of +.20, and implied volatility stands at 45%. The next day, however, implied volatility rises to 46% (or 1 percentage point), pushing the October 50 call’s value to $4.20.

In conclusion, familiarizing yourself with the “Greeks” can help you better understand the risks that come with options trading. Acquainting yourself with this mathematical system can also prepare you for the consequences of a stock’s volatility on an option, and can help you estimate your profit potential.

For more options-centered educational content, or to see which stocks are heating up the options pits each day, visit my home base at SchaeffersResearch.com.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

blog comments powered by Disqus