Guy Halpin In options trading there are four variables, termed the ‘Greeks’. They consist of delta, gamma, theta and vega. The Greeks tell the astute options trader how a change in the underlying stock price, time to expiration or implied volatility will affect a position(s). In this article, I am going to explore the first two Greeks mentioned; delta and gamma.
Delta
Definition: The change in the price of an option relative to the change in price of the underlying security.
In plain English, delta answers the question of how much can we expect our position to make/lose for a one point move in the underlying. Long call options have a positive delta (0 to 1) whilst long put options have a negative delta (0 to -1).
For example, if a US long call option (each contract = 100) has a delta of 0.25, a $1 move up in the stock would lead to the option position gaining $25 in value ($1 x 0.25 x 100).
If we had -
- 2 contracts our position would increase in value by $50
($1 x 0.25 x 200)
- 3 contracts - increase by $75
($1 x 0.25 x 300)
- 4 contracts - increase by $100
($1 x 0.25 x 400)
Should the stock go down by $1 then the opposite would apply. For each long call option held the position would decrease in value by $25.
The deeper a long call is In The Money (ITM) the closer the delta value is to 1. Similarly, the deeper a long put option is ITM the closer the delta will approach to the value of -1.
Gamma
Definition: The change in the delta of an option with respect to the change in price of its underlying security. Gamma helps you gauge the change in an option's delta when the underlying asset moves.
In simple terms, gamma answers the question: what will the new delta be if there is a $1 movement in the stock price. Gamma is commonly labelled the delta of delta. In the above example, we used a delta of 0.25 and let’s have a gamma of 0.05. If the underlying stock increased in value by $1 then the delta of the long call option would increase by 0.05 to 0.30.
Options that are At The Money (ATM) have the highest gamma value. This means the option will gain value at the fastest rate and thus provide the best return on investment (ROI). However, be warned because this is a double-edged sword. If the underlying makes an unfavourable move and you are trading ATM options, the position will lose value at the fastest rate and hence produce the poorest ROI!
As an option trader setting out to learn about the world of options, it may take some time before you totally understand the Greeks and how they affect the different strategies. Once you fully comprehend them, you will have another valuable piece of information to select and manage positions. This will ensure you are maximising your return whilst controlling risk. In the not too distant future, I will delve further into the Greeks family tree and cover delta and gammas sisters; theta and vega.
Make it happen,
Guy Halpin