The terms used to describe the various aspects of option pricing are "Greek" to many new option traders. That is probably because some of these terms come from the Greek language. Others are simple English but when used in "option-speak" they take on an entirely different meaning. I will try to demystify some of them here.

I discussed the first two terms in the prior Options 101 newsletter but I am repeating them here in order to get all the definitions in one newsletter.

The price you pay for an option is called the "premium" and it is made up of two parts. The parts are called "time value" and "intrinsic value."

Intrinsic value is the amount of "stock value" in an option. If a stock were at $27 the $25 call option would have $2 of intrinsic or stock value. The balance of the premium would be time value or "extrinsic value."


Greek terms are used to define the changes in an option premium.

Delta - is the rate of change in an option premium relative to the change in the price of the underlying stock.

Gamma - is the change in the Delta of an option premium relative to the change in the price of the underlying stock.

Theta - is the rate of change in the time value of option premium in relation to the expiration date. Theta increases, as the expiration date gets closer.

Vega - rate of change in an option premium as volatility changes.

Zeta - percent of change in an option premium relative to a one percent change in implied volatility.

For 99% of option traders the only Greek you will ever be concerned with is the Delta. The Delta is the change in the option premium in relation to the change in stock price. Unless I am mistaken the only thing most traders want to see is a change in their option premiums based on the stock moving in their direction. Notice I did not say up! There are two sides to every market and option traders make money in both directions.

Delta is the key to profit or at least minimum loss in option trading. This is subject to much discussion depending on what type of trader you are talking with. If the trader likes OTM options then they are counting on the rest of the Greeks as their salvation as their option premiums decay into oblivion.

I am a Delta trader. This means I like to buy/sell very high Delta options and stay far away from OTM strikes.


In this example you can see the various breakeven points and how much the stock must move before the investor can make a profit.


The stock value of an option is very important. Should the stock go flat or slow its rate of climb the time value of the option will decay quickly but the stock value will always remain. Owning an option that is well out of the money is like holding a lottery ticket. It may have value eventually but it more than likely will not. Holding a deep in the money call option is like holding cash. It has value and will always have value until expiration as long as the stock price holds.

I took this long way around to explain how Delta works. If you have an option that is deep in the money then the delta is very high and approaches 1.00. This means that for every dollar the stock price moves in your direction the option price moves $1.00 as well. It is very rare to get a 1:1 movement and that only occurs on very deep in the money options.

The delta on an option that is $5.00 out of the money on a low price stock is typically .25. That means for every $1 move in the stock price the option premium moves .25 cents. At the money options typically move .50. This is why I like deep in the money options. If the stock moves $5 in my direction I want to capture as much of that $5 as possible. Of course if the stock price moves against me then my option value loses $1 for every $1 drop in the stock price. Options deep out of the money can have very low deltas and move as little as a nickel for every dollar the stock prices moves.

Delta Chart

You can see by this example that the farther out of the money the option is, the smaller the benefit from the stock's price move. Once the stock price passes the strike price the delta increases quickly.

Volatility

There are two basic kinds of volatility, which affect option pricing and premiums. There is "historical volatility" which is a measure of the actual volatility for the last 21 days. There is also "implied volatility" which is the calculated by using the Black-Scholes formula for option pricing. This is what the market thinks the option is worth. If the stock price stays the same and the premiums rise then the market is "implying" that the option is worth more. This is usually due to some outside event other than normal option pricing.

If drug stock "DRUG" announced that the FDA had refused to review a drug application and the stock dropped -20% the options on DRUG would adjust accordingly. If the stock stayed at the new price for several days as new rumors abounded then options could rise in price as the markets priced in the higher "implied volatility" because of a possible impending announcement.

Sometimes stocks in the same sector and at the same price can have different implied volatility. As an example let's use Chevy Tahoe "TAHO" and Dodge Viper "VIPR" as fictitious stocks. They are both in the same sector and trading for $20. The next month $25 call option on TAHO is $.95 cents. The $25 call option on VIPR is $1.95. Same stock price, same sector. VIPR has a much higher implied volatility than TAHO.

Assume you are writing car insurance on these companies. A Chevy Tahoe would have significantly less risk than a Dodge Viper. Who would be more likely to make a claim? The options market is a way to insure risk in stock prices. There are a lot more Tahoe SUVs on the road than Dodge Vipers. In this example that is the equivalent of having a lot of shares outstanding. TAHO is not likely to go shooting up in value next month with six million Tahoe cars on the road. However, VIPR prices with only 5,000 cars in circulation can move very quickly if buyers appeared. Similarly option writers are not willing to take the same risk on GoPro as they are on GE. They want a higher insurance premium to compensate for the possible loss of their stock if the options were exercised.

Key points:

Delta

Is normally 100% for deep ITM options, 0% for deep OTM options.
Approaches 0% or 100% as expiration approaches.
Normally 50% when stock price equals the strike price.
Increases for OTM options if volatility increases.
Decreases for ITM options if volatility increases.
Represents the change in option price for a change in stock price.
Delta is positive for calls, negative for puts.

Gamma

Represents rate of Delta change due to change in stock price.
Increases as expiration date approaches.
Is highest at the money.

Vega

Longer-term options have higher Vega than short term options.
Higher for at the money, lower ITM, OTM.
More expensive stocks have higher Vega.
Calls and Puts for same option have same Vega.
Represents options change in price when volatility changes.

Theta

Represents the rate of premium time decay as time passes.
Increases as expiration approaches.
Highest at the money.
Increases in volatility increase Theta.

This section on definitions was not meant to be an encyclopedia of option terms but only the basic knowledge needed to trade options successfully. I strongly suggest you purchase any of the fine books available online for an in-depth education on options nomenclature.

If you like the options education you have been receiving and you are on a free trial then now is the time to subscribe. Don't wait until you miss a newsletter to decide you want to take the plunge.

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We have a lot of new traders reading the newsletter and I get a lot of questions. Over the next several weeks I am doing a multi part mini course on options. How do the strategies work? I will describe all the various strategies including calls, puts, spreads, covered calls, naked puts, straddles, strangles, definitions, etc. Stay tuned!

Jim Brown

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