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The "Greeks"

The "Greeks" are measures designed to better understand how option prices change when the underlying stock changes in value and/or time passes by (and options decline in value).

My goal is to keep this discussion of Greek measures as simple as possible. It is not easy. I have tried many times to explain these terms to people in person. I have seen their eyes glaze over before I get past Alpha.

I'm sure you heard about the fellow who bragged that he could speak every language except Greek, and when asked to say something in a particular foreign language, answered "It's all Greek to me." Let's hope that isn't your answer next time you are asked about a Greek stock option measure.

I'll confine this discussion to three measures of market risk exposure - delta, gamma, and theta. Mathematicians gave these measures the names of Greek letters, or names that sound like they're Greek letters (vega, another measure which we will not discuss here, is not in the Greek alphabet, but sounds like it should be).

Delta, gamma,and theta are the three most important Greeks in the world of stock options, and each tells us something important about an option. If you own 100 shares of a company's stock, your market risk is easy to understand. If the stock rises (or falls) by $1.00, you gain (or lose) $100. It's not so simple with stock options. The most common way to measure market risk for an option is the Greek called delta.

Delta is the amount the option will change in value if the stock goes up by $1.00. If an option carries a delta of 70, and the stock goes up by $1.00, the price of the option will rise by $.70 ($70 since each option is worth 100 shares).

Owning an option which has a delta of 70 means that you own the equivalent of 70 shares of the company's stock.

All options do not have the same delta value. Deep in-the-money options have very high delta values (perhaps in the 90s), while way out-of-the-money options have very low delta values (could be under 10).

To make matters more confusing, delta values change over the life of the option, even if the price of the stock remains unchanged. An in-the-money option, which might have a delta value of 60 with a month to go until expiration, will have a delta value of essentially 100 on expiration Friday.

You can calculate the net delta value of your composite option positions by multiplying the delta value of your long options by the number of those options and subtracting the delta value of your short options multiplied by the number of those options. The resulting figure, net delta value, tells you how much the value of your current option portfolio will change if the underlying stock goes up by $1.00. It is perhaps the best measure of market risk at any given moment.

Most professional market makers who hold a variety of options in their account, some long, some short, some puts and some calls, calculate their net delta value continually throughout the day so that they don't expose themselves to more risk than their comfort level allows. Ideally, they like to be net delta neutral, which means that with their current configuration of option holdings, they do not care whether the market goes up or down.

Gamma is a measure of how much delta changes with a dollar change in the price of the stock. Just as with deltas, all gammas are different for different options. While you may establish a net delta neutral position (i.e., you don't care if the stock goes up or down), the gamma will most always move you away from delta neutrality as soon as the underlying stock changes in value.

If there is a lot of time left in an option (such as a LEAP), the gamma tends to be quite stable (i.e., low). This holds true for both in-the-money and out-of-the-money options. Short-term options, on the other hand, have widely fluctuating gammas, especially when the strike price of the option is very close to the stock price.

A perfectly neutral option strategy would have a zero net delta position and a zero net gamma position. As long as you deal with calendar spreads, you will never enjoy this luxury. You will always see your net delta position fall as the stock price rises, and watch your net delta position rise as the stock price falls. Gamma measures tend to do the same, which serves to accelerate the change in the net delta position of a calendar spread portfolio.

Occasionally checking out the net gamma position lets you know how big the change in your net delta position will be if the stock moves up or down in price. It helps you know how your exposure to market risk will change as the stock price changes.

Theta is my favorite Greek, because it tells me how much money I will make today if the price of the stock stays flat when I have my favorite positions (calendar spreads) in place. Theta is the amount of daily decay. It is expressed as a negative number if you own an option (that is how much your option will decay in value in one day).

On the other hand, if you are short an option, theta is a positive number which shows how much you will earn while the option you sold to someone else goes down in value in one day.

Theta tells you how many dollars you will make today if the stock stays flat. For me, knowing this number has some negative implications, however. If I'm at a restaurant on a night when the market didn't change much, I might remember the theta value that day - it was sort of "free" money I really didn't make any effort to earn. Oftentimes, I order a too expensive bottle of wine because of that silly theta number).

The ultimate goal of my favorite calendar spread strategy (which I call the 10K Strategy) is to maximize the net theta position in your account without letting the net delta value get so high or low that you will lose a lot of money if the stock moves against you.

This short discussion of the Greeks should be all you need to impress your friends next time you talk about the stock market. All you need to do is to get around to the topic of stock options, and drop a few Greek names on them (ask them if they know what their net delta position was yesterday, or did their theta increase much last week, and watch their eyes glaze over).

I have found that the Greeks are very effective conversation stoppers. Feel free to use them whenever the need arises.

For a free report entitled "How to Make 70% a Year With Calendar Spreads", sign up for our free newsletter.

Terry's Tips Stock Options Trading Blog

July 21, 2014

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Terry

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I would like to share with you the thinking behind these trades so next time this opportunity comes up (and it surely will in the near future), you might decide to take advantage of it yourself.

Terry

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Making 36%

Making 36% – A Duffer's Guide to Breaking Par in the Market Every Year in Good Years and Bad

This book may not improve your golf game, but it might change your financial situation so that you will have more time for the greens and fairways (and sometimes the woods).

Learn why Dr. Allen believes that the 10K Strategy is less risky than owning stocks or mutual funds, and why it is especially appropriate for your IRA.

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