Most people who trade options focus on the price of the underlying security. While this is certainly important, it’s not the only thing you need to consider when trading options. To get an options trading edge, you also need to understand the Greeks. In this post, we will discuss each of these concepts in detail and show you how they can help you become a more successful options trader!
We discuss:
What is the Intrinsic and Extrinsic value of an option?
What is Delta and how do we use it?
What is Theta and how do we use it?
Key Takeaways
Real quick guys, please comment and let me know your thoughts on this post.
Also, be sure and grab the FREE Simplified Options Strategies Trading Guide. I’ll put a link down below. It covers the different options strategies setups, how and when to put them on, max profits, and trade management. It’s a great guide to have by your side when trading options.
So let’s get started!
What is Intrinsic and Extrinsic value of a stock?
An option’s value is comprised of intrinsic value and extrinsic value. Intrinsic value is simply the amount an option is in-the-money by. Extrinsic value represents all option premium that is not intrinsic value.
Extrinsic value consists of 1) time value and 2) implied volatility. Because of time value, an options extrinsic value will diminish as expiration approaches. Options with high implied volatility will have greater extrinsic value than identical options with lower implied volatility.
In this example, we are buying an ITM in the money call. The intrinsic value is the current price 94.45 – 85 strike price or 9.45. The rest of the $11.95 option price is then Extrinsic value. This is the amount you pay to play.
What is Delta?
Delta measures the change in the price of an option relative to a change in the price of the underlying asset. In other words, it tells us how much the option price will move if the underlying asset price moves by $1. Delta can be either positive or negative, and it is always between 0 and 1 on the Call side and 0 and -1 on the Put side.
Puts: Delta is 0 – -1 so its negative. Put prices fall when the stock price increases. This is because if you own the Put you have the right to sell at the strike price.
Calls: Delta is 0 – 1 so it is positive. Call prices rise when the stock price increases. This is because when you own the Call you have the right to buy at the Call strike price.
1 is the delta if you own the stock.
.5 delta is ATM At The Money. It has a 50/50 chance that it will move up or down. As we know the market is perfectly priced as the market is extremely efficient and everything is taken into account.
A Call option with a delta of 1 is the same as owning the stock outright. If the stock price goes up $1 then the value of the option goes up $100. This is because there are 100 shares in 1 options contract.
Now consider a Call option with a delta of .74 as shown here in Citibank which is trading for $43.23. If the stock price goes up $1 then the value of the option goes up by $74 from $4.10 to $4.84.
It is roughly equal to the % chance that the option will be in the money before its expiration. So in this example it is saying that there is about a 74% chance that the stock price will remain above the $40 strike price. The further down we go in the money on the call side the more likely that the stock price will remain in the money at expiration.
When I buy LEAPS options I like to go deep in the money. This way when the stock price goes up I get the most leverage since the value of the option goes up the most as well.
How do we use delta?
We use delta to determine which direction we want to bet a stock or the market will move. If we think the market is going to go up we should have on more positive deltas. Conversely, if we think it will go down we should have more negative deltas.
We also use delta it to manage risks. We can pick our POP or probability of profit. We can sell a 14 delta 80 strike PUT in Disney. We collect $121 and have a 86% POP probability of profit. Or we could sell a 23 delta 85 PUT which will have a 77% POP and collect more premium at $208 upfront.
Of course with the 80 PUT, we keep the $121 max profit even if the stock moves down to 80. We only keep the max profit of $208 if the stock remains above the 85 short strike when selling the 85 PUT option.
What is Theta?
Theta is basically “pay to play”. It is how much an option loses in value each day due to the passage of time. Options are a decaying asset. Options lose value every day as they approach their expiration date. The amount of time left until expiration has a big impact on the Theta of an option. Options with more time remaining will have a lower Theta (i.e. they will lose less value each day) than options with less time remaining.
Theta is also affected by whether the option is in or out of the money. Options that are in the money will have a higher Theta (i.e. they will lose more value each day) than options that are out of the money.
How do we use Theta?
The best way to use Theta is to take advantage of it. We do this by selling options that have good Thetas. The IVR or Implied Volatility Rating is a measure of the volatility of a stock. In other words how much it moves. High IVR is directly correlated with being able to collect high theta and option premiums!
On the other hand, theta is the enemy of buyers of options. As buyers we want a long period so that there is very little theta decay. So we like to buy options that have low Thetas.
Lastly, Theta can be used to manage risk. Options that have high Thetas are riskier than options that have low Thetas. This is something that needs to be taken into account when managing a portfolio of options. Consider rolling options trades at 15-21 DTE Days To Expiration. Once we get below 15 DTE, the theta decay accelerates fast and the stock price is less predictable.
What is Gamma, Vega and Rho?
I am lumping together Gamma, Vega and Rho for a couple of reasons. First is that if you manage your Deltas and Theta, then Gamma, Veg and Rho all fall in line and are managed as well. So I typically focus and use Delta and Theta.
That said, Gamma is how much Delta changes with a $1 change in the share price. Gamma is accelerating Delta. Gamma rises as we get closer to expiration. This is why we look to close or roll before expiration. By doing this we add time value.
When we are close to ATM “At The Money” Gamma shoots up as well. When we are far out of the money, Delta will move toward 1 or -1. The further in the money we go, the less Delta is going to change with a $1 change in the share price.
Alright, that takes us to the next one.
Vega is how much an option’s price will change for a 1% change in the underlying asset’s volatility. In other words, it measures an option’s sensitivity to changes in volatility. Vega is always positive for both calls and puts.
Where Vega can get you is if you are buying a Call option and the price goes up. When the price goes up you expect the option price to go up to, right? Well as the price goes up sometimes volatility gets crushed. When volatility falls the option price can fall due to the Vega. This is why it is usually not wise to buy Calls just before earnings since after the release the vol dives.
Rho rarely gets much press. It measures the price change for a derivative relative to a change in the risk-free rate of interest. Rho is usually considered to be the least important of all option Greeks.
Key Takeaways
Take advantage of the Greeks by selling options when implied volatility is high and buying options when implied volatility is low and if you have a directional opinion.
Place trades between 25 and 45 DTE Days To Expiration. This is the suite spot for collecting good theta premiums.
Look to roll trades at 15-21 DTE Days To Expiration. This greatly reduces risk before the time value starts to decay fast.
And that’s it! Those are the options Greeks. If you can master the Greeks then you will be well on your way to becoming a successful options trader.
Thanks for reading! I hope this helped you better understand the Greeks and how they play a role in options trading. Please remember to comment below, hit the thumbs up and subscribe so you will be notified of more videos like this.
Also, be sure and grab the FREE Simplified Options Strategies Trading Guide. I’ll put a link down below. It covers the different options strategies setups, how and when to put them on, max profits, and trade management. It’s a great guide to have by your side when trading options.
Happy trading and see you in the next one!
Let me know how you are using the Greeks!
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