The Greeks – What are they? What do they mean? How do I trade with them? Have you heard instructors say they sometimes don’t even look at the risk graph, but only the Greeks?
The first question is why do we have to have Greeks in the world of options? The answer is because there is more than one way that we can make or lose money trading options. With shares, aside from collecting dividends, we can only make money one way, with direction – by buying them or shorting them. But options have other components that affect their value. They decay as time passes by (Theta), they get affected by rises or falls in volatility (Vega), and they have a variable Delta (the directional component), whose acceleration is affected by yet another Greek called Gamma.
Here’s a basic summary of the Greeks before we go on:
Delta - the rate change in dollars of the whole trade for a $1 movement in the stock price. A plus sign (+) Delta means the trade makes the Delta amount in dollars if the stock goes up. A minus sign (-) Delta means we make the Delta amount if the stock goes down. So if we have a bullish trade, we need a (+) Delta, and vice versa.
Gamma - the rate of change of Delta. If Delta is speed, Gamma is the accelerator. The Gamma value gets added to Delta for every dollar move. For example, if Delta is +20 and Gamma is +2, then after the next dollar move the Delta will be 22. The sign in front of the Gamma is telling us whether we want the stock to move or not. For example, in a Straddle, Long Call or Long Put, Bull Call Spread or Bear Put Spread we want to have (+) Gamma. For Condors, Calendars and Butterflies we want to have (-) Gamma.
Vega - Don't be confused. Vega is not the Volatility, but rather the sensitivity of the trade to IV, or the actual dollar change for 1% point changes in IV. The sign in front of Vega is the direction Volatility needs to go to make money. For example if Vega is (+) $5.60 then we make $5.60 if Volatility goes up one percentage point but lose $5.60 if Volatility goes down one percentage point.. The opposite is true for (-) Vega.
Theta - Time Decay. The amount that the options will decay or erode by as one more day passes. If Theta is (+), the trade makes that amount, but if Theta is (-) the trade loses that amount.
I’m sure we’ve all heard the example of buying a call and being right on direction, yet our option still loses value. This could be due to a crush in volatility, a decay in value due to too much time passing by, or the option being less than 30 days from expiry. So for each trade, we have to get as many of these Greek players on our team as we can.
As Optionetics Instructor Nick Gazzolo says, “Trading is all about trade-offs”. We can’t get all the Greeks to be in our favour – there will always be one working against us. The idea is to try to hedge that Greek as much as possible, or in other words have minimal exposure to the “Bad Greeks”.
In Part two of this series, we will look at the Greeks in some trades and see how the trades would behave given their Greeks. We’ll also learn how to construct a trade with the Greek values you desire! To be continued ...
Manage your Greeks!