In
any position, whether purchasing a CALL or entering a multi-leg trade, you can
estimate a set of risk parameters known as ‘option greeks.’ Each option contract
has its own collection of greeks which can be added arithmetically with other option
greeks that cover the same underlying asset. As positions become more complex,
traders pay close attention to these hedging parameters to ensure there is not excessive
risk from changes in underlying asset price, implied volatility, time erosion,
and interest rates.
Suppose
you buy an option contract on SPY with a delta of 70. What does that mean?
It is actually really simple. It means that if SPY goes up $1, then
the value of the contract you bought will appreciate by $70, holding everything
else constant. Conversely, if SPY drops by $1, then the position value
will depreciate by $70.
When
SPY moves $2, will your position appreciate by $140? No. This can be explained
by the second risk parameter commonly referred to as gamma. Gamma
measures how much the delta changes with movements in underlying asset price.
If gamma is positive, then you would expect a positive $2 move in the
price to benefit the position by more than $280 ($140 X 2). Once again
this was because gamma, the partial derivative of delta (second derivative with
respect to price), is positive.
The
third parameter is vega, which is a measurement of the option contract’s sensitivity
to changes in implied volatility. This is important to note because a
change in implied volatility will directly affect an option contract price.
A positive vega means that your position will appreciate from an increase
in implied volatility, and a negative vega will appreciate from a decrease in
implied volatility. Buyers are long volatility (positive vega) and contract
sellers are short volatility (negative vega).
The
fourth risk parameter is theta, which is the measurement of the option
contract’s sensitivity to daily time decay. It can either work for or against
you. Most inexperienced traders end up purchasing time premium from
sellers because they are hoping to hit a home run. However, selling premium (positive
theta) means that even if the stock stays flat you’ll still win as the value of
the position appreciates with time.
The
fifth risk parameter is rho, which is simply sensitivity to interest rate risk.
Typically for retail traders, this parameter is ignored. There is more of an emphasis
on other parameters that impact day-to-day prices more consistently.
Below is a chart of the major risk parameters and how they are all
related. In order to have success as an
options trader, you’ll need to have an intuitive understanding of how the
greeks relate to one another.
