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Making Sense of Price Moves With Greeks

On Tuesday, I sent you the first of a two-parter series on the importance of understanding the Greeks of options trading. These unique aspects of options help you understand pricing, and are key to planning your trades.

Now, let’s resume our discussion with a look at gamma.

You know from reading Part 1 that options prices change based on how the underlying security moves. Delta is the Greek that explains that change. When the stock price does move by $1, delta will need to be recalculated.

Gamma tells us how much to expect delta to change when the stock makes a $1 move.

Gamma tells us how volatile the option is. High-gamma options should provide larger gains than low-gamma options when the stock moves by $1. Because of the way it’s calculated, gamma is highest for options that are at the money. That’s one reason — which I mentioned in Part 1 — that at-the-money options offer a nice balance between risk and reward.

If you trade more complex strategies, like condors or spreads, gamma is important for selecting the right options. Gamma ranges from -1 to +1. Complex trades should generally have a positive gamma, since that means the changes in delta should result in a profit on the trade.

While this is a useful idea, it’s not one beginning traders should worry about since these complex trades usually offer small gains compared to other options strategies.

To simplify all this for beginning traders: when comparing two short-term options, the one with the higher gamma should be the one with the highest potential rewards.

The next Greek, vega, tells you how much the price of the option should change for every 1% change in the volatility of the underlying security.

Pricing models are built on the principle that increases in volatility generally make options more valuable. So vega can help traders find options that are likely to make large, short-term moves.

If you simply want to make a trade based on volatility, you could screen for high-vega options. If you expect volatility to increase, buying these options could be the best strategy. If you expect volatility to decrease, selling high-vega options could be the best strategy.

The last Greek is theta, which shows how much an option’s price should change every day.

All options have an expiration date. As we get closer to that day, the time value of the option decreases because it becomes less likely there will be a large move in the price of the stock. At expiration, theta is zero. Prior to expiration, it is generally a small value that declines slightly every day.

Of course, theta is only an estimate of how the price will change every day. Theta is affected by the other Greeks and it’s important to remember that the precise interactions between all the variables in the pricing models can’t be precisely forecast.

That means the Greeks can be useful to consider, but they are only estimates of the variables in the pricing models. The Greeks, like prices, will change over time and the exact changes are not as predictable as we’d like them to be.

Now, here’s the bottom line: Individual traders can honestly ignore the Greeks, for the most part.

Market makers are always monitoring their pricing models. If anything unexpected occurs, they will quickly buy or sell to drive the prices back to where they belong.

This is good news, because it means they provide the liquidity for us to trade. In fact, because they follow market action so closely, we never even need to look at the Greeks once we define our trading models.

Still, as True Options Masters, it’s important to understand how all these factors impact options prices behind the scenes. The more we know about these instruments, the less likely we are to be caught off guard by their moves.

Regards,

Michael Carr, CMT, CFTe
Editor, One Trade

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