Trading options without an understanding of the Greeks is like flying a plane without the ability to read instruments. In this article, I will try to describe how to use the options Greeks to your advantage.
First, a quick reminder for those less familiar with the Greeks.
The delta is the rate of change of the price of the option with respect to its underlying price. The delta of an option ranges in value from 0 to 1 for calls (0 to -1 for puts) and reflects the increase or decrease in the price of the option in response to a 1 point movement of the underlying asset price. In dollar terms, the delta is from $0 to +$100 for calls ($0 to -$100 for puts).
The theta is a measurement of the option's time decay. The theta measures the rate at which options lose their value, specifically the time value, as the expiration draws nearer. Generally expressed as a negative number, the theta of an option reflects the amount by which the option's value will decrease every day. When you buy options, the theta is your enemy. When you sell them, the theta is your friend.
The vega is a measure of the impact of changes in the Implied Volatility on the option price. Specifically, the vega of an option expresses the change in the price of the option for every 1% change in the Implied Volatility. Options tend to be more expensive when volatility is higher. When you buy options, the vega is your friend. When you sell them, the vega is your enemy.
The gamma is a measure of the rate of change of its delta. The gamma of an option is expressed as a percentage and reflects the change in the delta in response to a one point movement of the underlying stock price. When you buy options, the gamma is your friend. When you sell them, the gamma is your enemy.
Let's compare two possible non-directional trades using Apple (AAPL) options and the impact of the Greeks on those trades. The stock is currently trading at $493.
- Buy AAPL February 2012 490 put
- Buy AAPL February 2012 495 call
The trade can be done for a debit of $1,262. The trade Greeks are:
The current IV (Implied Volatility) of the option is about 25%. 5% increase in IV will cause the trade to gain $295 or 23%. 5% change in the stock price (in either direction) will produce a ~90% gain. Every passing day will cause the trade to lose 6.9% due to the negative theta (all other factors equal).
- Buy AAPL March 2012 490 put
- Buy AAPL March 2012 495 call
The trade can be done for a debit of $2,955. The trade Greeks are:
5% increase in IV will cause the trade to gain $615 or 20.8%. 5% change in the stock price (in either direction) will produce a ~25% gain. Every passing day will cause the trade to lose 1.5% due to the negative theta (all other factors equal).
Comparing the two trades, we can see the following:
- Both trades are almost delta neutral since the stock is almost in the middle between the strikes.
- The theta is your worst enemy as we get closer to expiration. The February trade is losing 6.95% per day compared to only 1.47% for the March trade.
- The gamma is your best friend as we get closer to expiration. Please notice the huge difference between February gamma and March gamma. Large gamma of the February trade will cause significant gains even after a small move.
- The vega is your friend. If you buy options when IV is low and it goes higher, the trade starts making money even if the stock doesn't move. This is the thesis behind many pre-earnings plays.
If you expect a big move, go with closer expiration. But if the move doesn't materialize, you will start losing money much faster, unless the IV starts to rise. It basically becomes a "theta against gamma" fight. When you expect an increase in IV (before earnings for example), it's a "theta against vega" fight, and the large gamma is the added bonus.
When you are net "short" options, the opposite is true. For example, take a look at the following Russell 2000 Index (RUT) trade I shared with SA readers on December 6, 2011, about six weeks before January expiration:
- Buy RUT January 2012 670 put
- Sell RUT January 2012 680 put
- Sell RUT January 2012 800 call
- Buy RUT January 2012 810 call
This trade is called an Iron Condor. The Iron Condor is a combination of a bull put spread and a bear call spread. This is one of my favorite strategies for sideways markets. I usually trade the Iron Condor on indexes like the Russell 2000, the S&P 500 or the NASDAQ 100 or index ETFs like Russell 2000 (IWM) and S&P 500 (SPY).
Iron Condor is a vega negative and theta positive trade. That means that it benefits from the decline in Implied Volatility (IV) and the time decay. If you initiate the trade when IV is high and IV is declining during the life of the trade, the trade wins twice: from the declining IV and the time passage.
However, it is also gamma negative and the gamma accelerates as we get closer to expiration. This is the reason why I don't like holding the Iron Condor trades till expiration. Any big move of the underlying will cause big losses due to a large negative gamma.
The gamma risk is often overlooked by many Condor traders. Many newsletters initiate the Iron Condor trades only 3-4 weeks before expiration to take advantage of a large and accelerating positive theta. They hold those trades till expiration, completely ignoring the large negative gamma and are very surprised when a big move accelerates the losses. Don't make that mistake.
One possible strategy is to combine vega negative and theta positive trades with vega positive and theta negative ones.
Conclusion: when you trade options, use the Greeks to your advantage. When they fight, you should win. Like in a real life, always know who is your friend and who is your enemy.