Know your Greeks
Another consideration for how options can be valued is through a series of factors known as the “Greeks.” The first of these is Delta. Calls have positive Delta between 0 and 1, and puts have negative Delta between 0 and -1. Delta represents the level of price move in an option you expect to see, based on changes in the underlying. If the underlying moves one point, you expect it to move point for point with the underlying. A 0.50 Delta means you expect a 50¢ move for every $1 of movement in the underlying price.
The second Greek is called Gamma. This is the rate of Delta‘s speed of movement. It is the momentum (or acceleration) of the Delta. High Gamma implies a high level of responsiveness by an option to movement in the underlying.
A third Greek is Theta, which measures time decay. As expiration approaches, the rate of time decay in the premium of the option increases. Theta measures the degree of price change in the option for an equal move in the same time period by the underlying. Theta is going to be different for at-the-money options (when the strike price is at or near the current price per share) than for in-the-money or out-of-the-money options. This “moneyness” measures the distance between underlying price and strike.
Vega, a fourth Greek, defines change in call or put premium value for each change in volatility. The volatility is an estimate of how much movement you will see in the option over time and based on a series of assumptions based on current conditions in the underlying and in the option itself.
It is extremely important to understand the Greeks before you begin trading options.
The Chicago Board Options Exchange (CBOE) provides a free calculator (cboe.com/trading-tools/calculators), which performs the various calculations of the Greeks.
To anyone new to options, what constitutes long and short positions can be confusing. Following is a table that explains it.
A difficult aspect to options trading is in understanding the differences between long and short. A long option is a buy of either a call or a put. A long trader buys the option as a first step and closes it later.
A short option is a sell position. In this case, the first step is a “sell to open” and the last step is a “buy to close,” so the sequence of events is reversed: sell, hold and buy. With these distinctions in mind, the question remains: Are options always high-risk?
Some types of options trading are high-risk. Selling calls, for example, without also owning shares of stock, is a “naked” trade and could lead to significant losses. But on the other side of the risk spectrum, selling a call when you also own 100 shares of stock is a very conservative trade. It generates income, but you still earn a dividend as well. This “covered” call eliminates the risk of a short sale. In the event of exercise, you are required to deliver 100 shares at the current price. Having those shares on hand makes this an easy final step. And if the strike of the covered call was higher than your original cost per share, you also get a capital gain on the stock.
In between the uncovered or naked call and the covered call is broad range of trades. These run the full range from high-risk to extremely conservative. So the two overall rules about options are: Learn the terminology and trading rules, and understand the true risk level before making a trade.
An excellent way to learn about options trading without putting money at risk is to “paper trade” first. This is a system of trading in an artificial or “virtual” portfolio that behaves exactly like the real thing; but no money is placed at risk.
Many exchanges, brokerages and trading platforms offer paper trading.
Once you learn the basics, you need to decide for what purpose you will trade options. Options can be used to take directional bets on an underlying market, as a risk management tool or as a bet on movement in volatility. The great benefit of options over trading an underlying security or futures contract is that you can define your risk and make a much more precise trade. When buying an option, whether as a directional play or for risk management purposes, you only risk the premium you pay. Selling naked options entails more risk, but not any greater risk (other than leverage) than in an outright position in an underlying security or futures contract.
When using options it is best to first define what you are trying to accomplish. Are you making a directional bet? Are you hedging an existing position? Are you looking to benefit from an expected spike in volatility? Once you know that and have an understanding of the Greeks so you know where to expect prices to move based on the movement of the underlying, you can decide on which options tools to use.