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Posts Tagged ‘theta’

A Short Summary of the Greeks

Tuesday, November 15th, 2016

Academics have developed a number of mathematical measures to get a better handle on stock option prices.  They call them the Greeks, even though some of the measures really don’t exist as Greek words, but sound they should.

Several subscribers have written to say that the Greeks totally befuddle them.  This little report is my attempt to summarize them in 100 words or less (for each Greek, that is).  I hope it might make them a little less confusing to you.

Terry

 A Short Summary of the Greeks

Delta is the number of cents an option will go up if the stock goes up by $1.00.  If you multiply the delta of an option by the number of options you own, you get a figure that represents the equivalent number of shares of stock you own.  If you own 10 options that carry a delta of 60, you own the equivalent of 600 shares of stock.  (If the stock goes up by $1, your positions will increase by $600 in value, just as if you owned 600 shares of the stock).

Your Net Delta Position is the sum total of all the delta values of the options you own, less the delta values of the options you are short (i.e., sold to someone else).  The closer that your Net Delta Position is to zero, the less you will be affected by changes in the price of the stock.  Generally, your goal is to remain delta neutral (i.e., as close to zero as possible).  However, if the market is rising quickly, you want to maintain a reasonably positive net delta value rather than zero.

What is reasonable?  How far is up?  Why is a mouse when it spins? Imponderable questions, all.  (I put this paragraph here to let you know that if you think the Greeks are confusing, it could be worse.  You could really go crazy if you tried to understand some questions).

Gamma is a number that tells you how much your delta will change if the stock goes up by $1.00.  So if you have a net delta position of 600 (meaning you will be $600 richer if the stock goes up $1), and your net gamma is –800, you know that once the stock has gone up that dollar, you will be short the equivalent of 200 shares of stock, and wishing that the stock would fall.  Gamma helps you know the extent, if any, of the upside protection you possess.

Theta is the amount that an option will fall in value in a single day.  If the price of the stock remains flat, all options decay in value every day.  Theta tells you how much. The heart of the 10K Strategy is that we own long-term calls which carry a low theta value, and we sell to someone else short-term calls which carry a higher theta value.  Our profit comes in the difference between these two decay rates.

The ultimate goal of the 10K Strategy is to maximize the position Theta value while maintaining a low net Delta value and a low net Gamma value to protect against adverse stock price changes.  

All About Back Spreads

Sunday, December 9th, 2012

Back spreads and ratio spreads are usually discussed together because they are simply the mirror image of each other. Back spreads and ratio spreads are comprised of either both calls or both puts at two different strike prices in the same expiration month. If the spread has more long contracts than short contracts, it is a Back Spread. If there are more short contracts, it is a Ratio Spread.
Since ratio spreads involve selling “naked” (i.e., uncovered by another long option) they can’t be used in an IRA.  For that reason, and because we like to sleep better at night knowing that we are not naked short and could possibly lose more than our original investment, we do not trade ratio spreads at Terry’s Tips.

Back spreads involve selling one option and buying a greater quantity of an option with a more out-of-the-money strike. The options are either both calls or both puts.
A typical back spread using calls might consist of buying 10 at-the-money calls and selling 5 in-the-money calls at a strike low enough to buy the entire back spread at a credit. 
Ideally, you collect a credit when you set up a back spread.  Since the option you are buying is less expensive than the one you are buying, it is always possible to set up the back spread at a credit.  You would like as many extra long positions as possible to maximize your gains if the underlying makes a big move in the direction you are betting. 
If you are wrong and the underlying moves in the opposite direction that you originally hoped, if you had set up the back spread at a net credit at the beginning, all of your options will expire worthless and you will be able to keep the original credit as pure profit (after paying commissions on the original trades, of course).
Call back spreads work best when the stock price makes a large move up; put back spreads work best when the stock price makes a large move down.
One of the easiest ways to think about a back spread is as a vertical with some extra long options. A call back spread is a bear vertical (typically a short call vertical) plus extra long call options at the higher of the two strikes. A put back spread is a bull vertical (typically a short put vertical) plus extra long put options at the lower of the two strikes.
The purpose of a back spread is to profit on a quick extended move toward, through and beyond the long strike. The purchase of a quantity of more long options is financed by the sale of fewer short options. The danger is that because the short options are usually in the money, they might grow faster than the long out-of-the-money options if the stock price moves more slowly or with less magnitude than expected. This happens even faster as expiration approaches. The long out-of-the-money options may lose value despite a favorable move in the stock price, and that same move in the stock price may increase the value of the short options. This is when the back spread loses value most quickly. This is depicted in the “valley” of the risk profile graphs. The greatest loss in the graph occurs at exactly the strike price of the long options.

There are two reasons that I personally don’t like back spreads.  First, they are negative theta.  That means you lose money on your positions every day that nothing much happens to the underlying strike price. 

Second, and more importantly, the gains you make in the good time periods are inconsequential compared to the large losses you could incur in the other time periods.  If the stock moves in the opposite way you are hoping, you end up making a very small gain (the initial credit you collected when the positions were originally placed).  If the underlying doesn’t move much, your losses could be huge.  On the other hand, in order for you to make large gains when the market moves in the direction you hope it will, the move must be very large before significant gains come about.

Here is the risk profile graph for a back spread on SPY (buying 10 Dec-12 142 calls for $1.55 and selling 6 Dec-12 140 calls for $2.78 when SPY was trading at $142.20 and there were two weeks until expiration):

You have about $1100 at risk (the $1200 maintenance requirement less the $115 credit (after commissions) you collected at the outset.  If the stock falls by more than $2.20 so that all the calls expire worthless, you would gain the $115 credit.  If the stock moves higher by $2, you would lose just about that same amount.  It would have to move $2.20 higher before a gain could be expected on the upside, and every dollar the stock moved higher from there would result in a $400 gain (the number of extra calls you own).

The big problem is that if the stock doesn’t do much of anything, you stand to lose about $1000, a far greater loss than most of the scenarios when a gain could be expected.  In order for you to make $1000 with these positions, the stock would have to go up by $5 in the two-week period.  Of course, that happens once in a great while, but probably less than 10% of the time.  There there is a much greater likelihood of its moving less than $2 in either direction (and a loss would occur at any point within that range).

Bottom line, back spreads might be considered if you have a strong feeling that the underlying stock might move strongly in one direction or another, but I believe that there are other more promising directional strategies such as vertical spreads, calendar or diagonal spreads, or even straddles or strangles that make more sense to me.

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I have been trading the equity markets with many different strategies for over 40 years. Terry Allen's strategies have been the most consistent money makers for me. I used them during the 2008 melt-down, to earn over 50% annualized return, while all my neighbors were crying about their losses.

~ John Collins