Written by Aussie Rob
It was a beautiful moonlit evening. I could hear a slight breeze blowing through her jet-black hair and the sea was crashing ever so slightly on the beach…. Ohhh, no it wasn't, it was Expiration Friday and I was analysing my trades for next month. Gidday, it's Aussie Rob here and My BIG Fat Love Affair is all about my favourite Greek, 'Delta'. Well, kinda!
No, not Delta Goodrem (the spunky Aussie singer), I am talking about one of the major Greek measurements used in options trading. Delta is the relationship between the movement of the stock and the option price. So do ya think it's important to know about Delta? Too right it is!
Here's how it works. If an option has a Delta of 100, then it should move in tandem with the stock. If it has a Delta of .50, then for each dollar the stock moves, the option should move 50c. You can calculate this by dividing the option move by the stock move, but if you're like me and don't get too excited about math, your broker's website or trading platform should list option Deltas. Here are a couple of definitions you should know before we progress:
The option strike price is the same as the stock price.
In the Money (ITM):
For Calls: The option strike price is below the stock price. For Puts: The option strike price is above the stock price.
Out of the Money (OTM):
For Calls: The option strike price is above the stock price.
For Puts: The option strike price is below the stock price.
The following chart can help you estimate an option’s Delta in correlation to the movement of the underlying stock.
Call options have a +Delta while put options have a –Delta. These are approximate values but as you can see, ITM strike prices have a higher Delta, therefore, OTM strike prices have a lower Delta. So, you don't have to be a rocket scientist to realise that new traders should always buy ITM options.
Why? Well, another way of explaining Delta is that it is the percentage probability of the option expiring in the money. For example, if an option has a Delta of 80, then it has an 80% chance of expiring in the money. On the other hand, an option with a Delta of 30 has a 30% chance of expiring in the money. Options that expire out of the money expire worthless, so the name of the game is to have your option expire in the money so you make money.
ITM options are a lot more expensive than OTM options. Why? Simple, if they have more of a chance of expiring in the money, then ya gotta pay more for them. It's all about risk – the higher the risk, the higher the return. The lower the risk, the lower the return. You gotta know what type of trader you are and what your risk tolerance is before you can implement a trading plan. My rule of thumb for new traders who buy options is to buy one strike ITM and to place a stop loss ATM.
Now, I've still got a few more Greek fillies to tell ya about.
Gamma measures the rate of change of an options Delta in relationship to the change of the underlying instrument (stock, futures contract, etc.) For example, let's assume that Fosters is trading at 50 and its 45 call option has a Gamma of 0.05 and a Delta of 70. If Fosters moves to 51, the Delta should move to 75. Therefore the Delta should move 5. Clear as mud? Thought so… Doesn't excite me either!
Vega measures the change of an options price based on the change in implied volatility. For example, if Fosters has an option with a Vega of 0.50, the option's price will change by $0.50 for each 1% change in the option's implied volatility.
Theta measures the daily rate of time decay of an option. In other words, how much an option loses value each day. An option is a depreciating asset so you need to pay attention to time decay. For example, if Fosters has an option with a theta of -0.50, the option will lose $0.50 per day. This is assuming that both the stock price and volatility stay the same.
This reminds me of a story about one of my students. He sent me a sample of some of his trades, as he was flabbergasted that the stock was going up but his calls were going down.
"How can this be, Aussie Rob?"
Hmmm, "What do you know about Delta?" I asked him.
Guess what he replied?
"Who's she?"
One of his trades had a Delta of .09 and if I can remember correctly, I think the Theta was -0.25. Therefore, if the stock didn't move, the option would lose $0.25 per day. With a delta of .09, the option would increase in value by $0.09 for every dollar increase. Therefore, the stock would have to move close to $3 per day just to cover the Theta.
This guy was like most new options traders; they buy way out of the money options because they are 'cheap'. To me, a way out of the money option is NOT cheap. Why? Well if it has Buckley's chance of expiring in the money, then it's ridiculously expensive. Crikey, ya might as well roll up the greenbacks and smoke 'em…
A couple of days after I taught him how important Delta was, he was up 100%. That wasn't an improvement of 100%; his new trade returned 100%.
So, now do you think you should study the Greeks? They really aren't difficult when you get your head around 'em. Like I always say, "Everything's easy when you know how!" It just takes baby steps. Learn a little every day and you'll be surprised how quickly it will all come together and start making sense. Learning is like eating an elephant: One bite at a time!
Measures the change of an options value based on the change of interest rates. Therefore, as interest rates rise, so does the value of call options. Why? Because the holding costs increase.
You see, it costs money to hold something and this is factored into option pricing. If you didn't hold something, your money would be in a cash account earning interest, so holding something does have a cost because you are missing out on the interest.
Rho is the ugly sister with the personality of a dead fish. She only becomes exciting when interest rates change. She doesn't excite me too much; I'd rather date Delta any day!
The way you trade options really depends on market conditions. As they say, 'the trend is your friend', so you should always trade with the trend. In a bull market, buy calls. In a bear market, buy puts. Unfortunately, most traders have a tendency of always wanting to go long, so they buy calls. It's great to be an optimist and hope that something is going to go up but really, as traders, we should be stacking as many odds in our favour, so we have a better chance of making a profit. To me, that's what trading is all about – making money.
So, if you just have to go long in a bear market, be more cautious and buy options with higher Deltas. When the market conditions change and things become more bullish, adapt your trading to buying options with lower Deltas. That'll enable you to get a bigger bang for ya buck. Just remember though, "Delta is the percentage chance of an option expiring in the money."
In conclusion, Greeks really are something that you should have a love affair with. They help you gauge the rate of change in an option based upon a change in one of the known variables used to estimate the fair value of the option. Yeah I know, it all sounds a bit 'Greek' but hopefully I've triggered a little spark that'll make ya wanna learn more about them. If ya wanna become a consistently profitable options trader, then ya gotta learn this stuff. Put in the effort and your account balance will thank you for it!
Finally, the particular Greek symbol used bases its valuation subject to all other variables remaining the same. Hmmm… how can that be when change is virtually constant? Well, like everything in this world, nothing is perfect. The Greeks are not perfect, but they're an option trader's best friend. I think you'll agree that it's time you get intimate with them.
One of Aussie Rob's special qualities is being a natural educator. He has the ability to take a concept, idea or scenario and turn it around to relate to simple real life situations. Aussie Rob's motto is "Everything's EASY when you know how", and he certainly has proven this point again and again. He has ensured his students are well informed, well armed, and in control of their own funds. www.aussierob.biz
