Ok - Greeks
What are Greeks? Greeks are critical to understanding options. They are very complicated if you haven't been exposed, but a true study of them will yield a lifetime of knowledge. Once you get a feel, and see how they work in practice, you will ultimately use them as inherent knowledge moving forward. This is the highest level overview and you need to read it if you don't yet have a full understanding of what they are, how they are calculated, what they do to an option's price, and how they can affect your trades.
Option Greeks: The 4 Factors to Measure Risk (investopedia.com). I'll try to simplify below, but please come back and read this too.
Now here's my ELI5 explanation. I'll start with an option chain showing a bunch of different measurements.
From left to right, non greeks first - the columns are Last (last contract price), net change ($ change in contract price), volume (today's contracts traded), open interest (total volume since that expiration came available). These are self explanatory.
Now the Greeks, left to right - Delta, Gamma, Theta, Vega, and Rho (and then followed by more classic columns ask spread, bid spread, implied volatility, bid, and ask.)
Assume you are bullish IWM in February. You think it has a good chance to get to $200. Let's focus on the $195 strike which is the closest to at the money right now. The contract value for a $195 IWM call with Feb 16 expiration is $3.18.
If IWM is at $195 or less upon expiration, this contract will be $0. If IWM is at $200, this strike will be $5.00. It's simply the price at expiration minus the strike. That's easy to calculate. But what happens before expiration and why does the contract price not match the current - strike? That's where the greeks come in.
Delta - This tells you how much $ the contract will rise with every $1 increase in the underlying. So we started with contract price $3.18 on the $195 strike with IWM at $194.41. Delta is $0.48, Assuming we're in a vacuum and nothing else changes, if IWM gets to $195.41, delta tells you the contract will gain $0.48 and be $3.66. Conversely, the contract will fall by that amount with a $1 move down in IWM.
And it's shown as a negative number on puts because it works opposite. For every $1.00 move up in IWM, the contract will fall by -$0.53. And if IWM moves down, the put will gain that amount.
But what about if IWM goes to $196.41, a $2 move in IWM? That's where Gamma comes in. Gamma is probably the most important to knowing the income potential of a play, as it measures how much the DELTA will increase with a $1 move in the underlying. A high gamma means your contract can rise/fall FAST with every $1 move. A low gamma means the contract value will increase/decrease at a relatively flat rate with every $1 move.
In this case, gamma is $0.05 for the call. This tells us that with a move of IWM to $195.41, the delta will increase from $0.48 to $0.53. While it doesn't necessarily mean that it will wait until $195.41 to then make the increase to $196.41 have a $0.53 gain, we can look at it in a vacuum that way for simplicity.
Just as with delta, gamma will reduce the contract by the same amount in a price move down. And puts will act opposite.
Ever heard of gamma squeeze? Think of it similar to a stock squeeze. A rapid increase in buying and selling that spirals on itself in one direction, usually from short covering or something similar.
What Is a Gamma Squeeze? - SmartAsset | SmartAssetQuote:
When stock prices experience rapid shifts, the conditions may be ripe for a squeeze. In this scenario, investors may find themselves buying or selling shares of stock outside their normal trading pattern in order to minimize losses. A gamma squeeze is an extreme example of this, in which investor buying activity forces a stock's price up often quite sharply. That's what happened in early June 2021 as shares of AMC experienced dramatic, sudden gains.
Quote:
A gamma squeeze can happen when there's widespread buying activity of short-dated call options for a particular stock. This can effectively create an upward spiral in which call buying triggers higher stock prices, which results in more call buying and even higher stock prices.
So now, we have a basic understanding of how our contract can be expected to move within a $2 range. But what if that range occurs over multiple days, or even weeks? That's where Theta comes in. Theta tells you more or less how much value the contract will lose with every day that passes. In this case, with every day that passes, our $195 Feb IWM call will lose $0.15. Let's see it in action. Let's assume the first $1 move happened at the end of the next day, and the second $1 move happened the following day.
We can now see that the $2 IWM increase we saw, where we expected our contract to rise $1.01, actually only rose $0.71. This is what's called "theta decay" or "time decay". This is one of the most overlooked factors of holding options beyond one day, and it can be CRUSHING the closer to expiration you get. Imagine if this $2 range took a week (again, in a vacuum, the only things happening are delta, gamma, and theta at this point). You're talking about 15 cents a day for 10 days. That's $1.50. You have now decayed well beyond the increase you expected to see from delta and gamma. THIS IS WHY OPTIONS ARE RISKY. As they approach expiration, theta takes over more and more. If you are in the money, this effect can be lessened as your contract comes closer to the actual difference between the strike and the underlying. But if you are out of the money, this decay is pushing your contract value closer to $0 with every day that passes.
Now let's extrapolate these out for an IWM move to $200, a $5 increase in IWM, and let's assume it takes 12 days. Here's what happened to your contract. And remember, we are still in a vacuum and this values shown are remaining unchanged from where they are today (they will change every single second that goes forward).
Your delta and gamma shows your contract gained $3.63, but the time decay stole $1.80 from you. Still a very profitable trade. $100 shares of IWM would have gained you $559 on a spend of $19,441, a 2.88% profit. But because you played the $195 call, you only spent t$318 and made $183, a profit of 57.55%. WOW!
But as with everything, I have to caution you on what would have happened if you were wrong and it moved away from you $5 in the other direction over $12 days. Buying IWM, you would have lost $500 or 2.57%. But your option would be here (again, in this vacuum).
Wipeout. In fact, just a $2 move down taking 4 days would have lost you over 50% of your value, and a $3 move down over 6 days would have destroyed 2/3 of your value. Just getting back to even at that point would be a miracle. And what kills even worse? Range bound. Imagine if a week passed and IWM was still at $194.41..
You would have lost 2/3 of your contract, with just a week left to expiration, thanks to time decay.
Now, there are other factors that have DIRECT impact of the options prices. These are harder to track so I won't diagram. But they are Vega and Rho.
Vega tells you how much your contract value will increase with each 1% gain in implied volatility (you can see the IV on the original options chart above.).
Quote:
Volatility measures the amount and speed at which price moves up and down and can be based on recent changes in price, historical price changes, and expected price moves in a trading instrument. Future-dated options have positive Vega, while options that are expiring immediately have negative Vega. The reason for these values is fairly obvious. Option holders tend to assign greater premiums for options expiring in the future than to those that expire immediately.
Vega changes when there are large price movements (increased volatility) in the underlying asset and falls as the option approaches expiration.
What Is Vega? Definition in Options, Basics, and Example (investopedia.com)And this chart tells us the contract would gain $0.15 with every 1% increase in volatility. a 5% decrease in volatility would decrease your contract $0.75. That can be just as punishing as theta, and they will be decaying you at the same time. Or maybe volatility increases and makes up for theta decay. It's very very complicated and if you don't understand the basics of volatility, I suggest you do some reading. It's too much to explain here. But know your vega. A high vega can be extremely rewarding and equally as punishing.
Rho is usually considered the least, as it measures the change in the option to a change in interest rates. A lot of leaps were caught off guard in 2022 as Rho started to affect options in a way that hadn't been seen in a long, long time.
Quote:
if an option or options portfolio has a rho of 1.0, then for every 1 percentage-point increase in interest rates, the value of the option (or portfolio) increases 1 percent. Options that are most sensitive to changes in interest rates are those that are at-the-money and with the longest time to expiration.
What Is Rho? Definition, How It's Used, Calculation, and Example (investopedia.com)For options expiring short term, it won't have much of an impact. Or maybe it will if we get a surprise in rates.
As 30k mentioned, there are also derivative second order greeks. These are greeks that affect other greeks. For example, Vanna measures how much the delta will change as volatility changes. So not only is volatility directly affecting your option through Vega, but it's affecting the delta in the background through Vanna. Vomma measures the rate of change of Vega with changes in volatility. Charm measures the theta (time) decay of the delta. Veta measures the time decay of Vega. Veta measures the change in Rho based on time decay. I wouldn't worry too much about these. Focus on delta, gamma, theta, and vega. Keep your eye on Rho for longer dated options.
This is a LOT to take in. But please learn and understand the basics. And know what you are getting into before your press the order button.
Two weeks ago I bought FTV $80 calls execting a 1-2 month price move from $75 to $85. There was low volume on the strike I chose. Delta wasn't high. Gamma wasn't high. Volatility was low. Why did I do that? What made me choose to do calls instead of buying the stock?
Had I bought the stock, I would have paid $7,500 hoping for a $1,000 gain. But since I believed in the move that was going to happen, the chart was building for a breakout, and I had been watching it for some time and preparing for this potential move with earnings approaching, I was able to get the $80 call for $0.50 each. Each contract was $50. A move to $85 based on simply subtracting the $80 strike would be a $5 contract, or 10x gain of my cost. And two contracts would cost $100 and equal the same return as buying 100 shares of the stock outright. Of course, my risk intensified, but I only risked $50 per contract, so my loss was limited much more than placing a stop on the shares would have been. Simply put, this option strategy uses the calls to mimic the move of the underlying stock for the potential to magnify the reward at a limited cost. The Greeks almost don't matter here. Now, had I been the only volume on that strike or even 25% of the total volume, I wouldn't have done it. Because there is a liquidity concern. If nobody is interested in that strike on that date, can I sell even if the value for me has gained?
What is your options strategy? Are you just guessing and hoping for the best? Are you aware how much decay will happen? Are you aware of the volatility and how much that can help or hurt you? Are you buying something with low gamma that isn't likely to intensify, therefore limiting your upside? These are things you should know.
