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Welcome to Part 2 of my series on the Greeks: ‘The Greeks – How will they behave throughout my trade?’
In this article we’re going to look at how two of the Greeks will behave throughout the life of a trade. It’s very important to know this. Why? So we can have some idea of whether our trade will make us more money at a given point, when it can’t make us any more money, or whether from a given point it will start to lose money. Any of these scenarios could be due of the effects of Stock movement, Volatility changes or Time Decay.
Let’s have a look at the risk graph of a Bull Call Spread. The stock is Apache Corporation (APA) and the Jan 08 100-110 spread was entered on December 6th, 2007.
Chart 1: Bull Call Spread
click chart for more detail
Did you know that the coloured time lines in the risk graph are a ‘visual’ representation of Delta, Gamma, Vega and Theta, as well as your profit or loss at any price and time point? You will know you have reached a new level in your trading when you can look at the risk graph and know how the Greeks are going to behave at any possible point in the trade, how they are going to change, whether the sign in front of their value will be positive or negative, when it will change, and where (and when) each particular Greek will make or lose you money! Phew! Now let me show you how to do this. With this skill, your trade management will rocket to another level. (For definitions of the Greeks please refer to Part 1 of this series.)
Delta: We can see that the Bull Call Spread has a capped profit at point 5. If the stock climbed higher than this point past $140, the trade can’t make any more money, so the delta there would be almost zero. From the Point 3 and higher, the Delta slows down, to the point where it will be zero, at approximately $145. You can see Delta’s deceleration in the shape of the red line curve, as it starts sloping steeper around the 4 point. The steeper it gets, the more Delta is slowing down. Now in trade management if the stock got to this point of the spread you will have to weigh up whether it’s worth staying in the trade, as your ‘money making machine’, the delta, is slowing down – but at this point, time decay is your friend as I will explain at a later date in Part 3 of this series of articles.
How does Delta slow down? The answer is Gamma! Gamma is the accelerator and decelerator. Gamma is a harder one to see in the risk graph, but the ‘rate’ at which the delta speeds up or slows down, or how dramatically the slope of the curve decreases or increases is the Gamma effect. Around point 1, Gamma starts to increase, meaning Delta will increase too, meaning our ‘money machine’ is working harder. You can see the curve sloping over more, the higher the stock goes. Here Gamma would be positive and increasing until roughly the 2 point, where it will still be positive, but decreasing slowly. At the 3 point, theoretically Gamma would be 0, where the lines converge. From the 3 to the 4 point (roughly) Gamma will become negative and at an increasing rate, and from the 4 point onwards Gamma (which at this point would be somewhere between about -5 and -12) would start returning back up to zero, and hit zero again at the $145 mark.
So how do you trade with the Gamma? To summarise, positive Gamma means the Delta will increase, negative Gamma means it will decrease. Once negative Gamma kicks in, on a directional trade, your money making machine slows down. So whilst that may sound like bad news, there is still good news to come! Part 3 of this series will go into Vega and Theta in the risk graph!
Manage your Greeks
Matt Baker
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