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.
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.