Option Investor
Educational Article

Knowledge Leads to Success

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All forms of trading, whether they involve stocks, bonds, commodities, or other monetary instruments, entail risk. In fact, there are very few ways to participate in a potentially profitable venture without the possibility of loss. For those who combine the unpredictable nature of equities with the sophistication of derivatives, the odds of losing money is even greater. Fortunately, traders who fully understand the capabilities of options are well equipped to manage the volatility of the stock market and, at the same time, take advantage of short-term trends in share values.

Trading complex securities such as stock- and index-based options can be very profitable for those who know the rules of the game. In contrast, individuals who do not master the fundamentals of options, such as pricing theory, profit-loss analysis, and the concept of leverage, are destined for failure. The first step in the learning process requires familiarity with commonly used terms and phrases. As with most financial instruments, the relationships between stock and option prices involve variables based on mathematical formulas. Collectively, they are known as the "Greeks," as most are named after Greek letters, and each one represents the amount of risk in a particular variable.

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Recall that when you buy an option, the entire purchase price is at risk and when you sell an option, the potential loss can be even higher because the collateral requirement may not be enough to offset a large, adverse movement in the price of the underlying issue. Despite the major differences in these two strategies, both depend largely on the first and most commonly used Greek; delta, for their success. As noted last week, delta is the amount of change in an option's price as compared to the movement of the underlying issue. Delta is generally regarded by retail participants as an indicator of leverage however professional traders commonly characterize it as a measure of risk. For example, the average option buyer knows that (long) out-of-the-money options offer greater percentage gains than in-the-money options, but with a much lower probability of profit. In contrast, savvy market players realize that while delta can be a helpful for comparing the risk versus reward outlook for different options strike prices, it is accurate only for very small moves in the underlying stock. They also know the reason behind this shortcoming; delta is not a static component it changes continuously based on the distance between the stock price and the option strike price. Indeed, the unique, intertwined relationship between stock movement and option value is why the other Greeks are so important.
 

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