The Greeks of option pricing tell us something about how we expect our options' prices to change when conditions change. Those conditions might be the changing price of the underlying, the passage of time, the rise or fall of implied volatilities or the change in interest rates. Most of us, especially when new to option trading, pay more attention to the effect due to price moves of the underlying. We may also be aware of the expected effect of the passage of time. More experienced traders will also look at the effect of changes in implied volatility. Implied volatility can be broadly understood as a spot measure of how volatile the underlying's price is expected to be between the current time and expiration.

The wise trader, whether experienced or newbie, will understand that none of those factors, those Greeks, can be isolated. None is "an island,/Entire of itself" (John Donne). In particular, the changing of implied volatilities can and does impact delta and theta, the Greeks related to price changes and time passage. It's been months since we've had a real thrashing in the markets with the attendant sharp rise in implied volatilities. I thought it might be time for a quick refresher on two of the effects of rising implied volatilities.

Rising implied volatilities impact delta, James B. Bittman reminds us in Trading Options as a Professional. Delta measures how much an option's price is expected to move with a one-point move in the underlying's price. Delta can be negative or positive. On a practical observed basis, I've never seen the absolute value of delta range above .99 (or 99 if your brokerage automatically applies the 100 multiplier) for a deep in-the-money option. Long calls have positive deltas, and puts, negative ones. That sign signals that calls theoretically gain in value if the price of the underlying goes up and theoretically lose money if the price of the underlying goes down. It's reversed for puts. In addition, selling those options rather than buying them reverses the signs of the deltas you have captured. If you've sold a call with a delta of .53 or 53 after the 100 multiplier is applied, then your position delta will be -53.

Complex options positions such as call debit spreads have deltas, too.

RUT FEB15 1170/1190 Call Debit Spread, Captured from OptionNet Explorer on January 22, 2015:

On the pulldown tab, the value of delta is a positive 13.15. A complex option position with this positive delta should theoretically decrease in value if price of the RUT drops.

Would it surprise you to know that I've seen such debit spreads rise in value when the RUT turns down, at least over a short distance?

Same Call Debit Spread about a Minute Later, with a Small Price Drop in the RUT:

The RUT has dropped from 1179.31 to 1178.64 in those few moments, a drop of 0.67 points. According to the +13.15 delta in the original chart, the loss should have deepened from the original -$35.00 to -$35.00 - (0.67)*13.15*$100= -$35 - $8.81 = -$43.81. Instead, the loss has decreased and is only -$10.00. Somehow, the spread gained $25.00 in value over that 0.67 price drop rather than losing an additional $8.81 in value, as expected.

This effect doesn't always occur, but I've watched it happen often enough to know that, for the purposes of this article, I could easily capture an instance of it happening by just waiting for a small pullback. Why does it happen? It's likely an artifact of rising implied volatilities due to the price drop. Three things may happen as a result of a price drop. Bid/ask spreads on the individual options may widen in odd ways, and that can impact prices. Those on the other side of your trade don't want to get caught by wild market action any more than you do, so they'll take care of themselves by widening bid/ask spreads.

A second point that relates deltas to changes in implied volatilities comes from Bittman. He notes, "Deltas change toward +0.50 when volatility increases and away from +0.50 when volatility decreases" (98). Let's look at deltas on the call debit spread example and determine if that happened. Remembering that OptionNET Explorer applies the 100 multiplier, we would need to convert Bittman's statement to "Deltas change toward +50 when volatility increases." The implied volatilities (IV's) of the options comprising the position are visible on the left-hand sidebars on the graphs. At the time the first graph was snapped, they were 57.12 and 43.99 for the 1170 and 1190 strikes, respectively. If Bittman were right, we would expect the 1170's delta to sink closer to 50 and the 1190's to rise closer to 50. In the second graph, the deltas were 56.77 and 43.36, respectively. The 1170's delta did sink closer to 50, as expected if we believe Bittman, but the delta of the 1190 sank, too, rather than rising as predicted.

What happened? As was discussed in last week's article, rising IV's will likely change differently for the at-the-money (ATM), in-the-money (ITM) and out-of-the-money options. A quick review of that article might be important if you've never seen a skew chart and can't picture one as you're reading further. In addition, the 1170's were ITM options and had some intrinsic value (the amount by which they were in the money) that wasn't impacted by the changing implied volatilities.

IV's aren't the same across all the calls in a certain series of options. The shape of the curve of IV's plotted against strike price shows that the IV's differs in different strikes. When a price move occurs, particularly a down move, skews may change, depending on whether market participants believe a move is short-lived or not. Changing skews may curve the line higher on the right-hand or left-hand side of a skew chart or perhaps on both sides.

In addition, the OTM 1190's were all extrinsic money, so all of its value was impacted by the changing implied volatilities. Perhaps over that short distance in RUT price decline, the all-extrinsic-value 1190's were losing money more rapidly than the nearer-the-money long 1170's with some intrinsic value.

Of course, if the RUT kept dropping, the delta-effect would likely catch up. The value of that call debit spread would drop. Can a trader predict exactly how that skew chart is going to change with each movement and plan accordingly? Probably not unless the trader has access to all the order books and can predict the way the market is headed. The point isn't to plan it all out exactly. The point is that you can't look at delta in isolation.

You may be despairing of ever calculating in advance the tangled-together effects of changing prices, rising or falling implied volatilities and the passage of time, among others. However, as I've mentioned previously, I'm no expert on implied volatilities. I knew to expect a small increase in prices on that call debit spread when prices dipped not because I'm great at calculus--although, ahem, I certainly used to be--but because I've watched this very effect through the years.

I'm back to the same advice I always give. Trade small enough that neither your trading account nor your confidence is devastated by the losses you definitely are going to incur as you learn these kinds of things. And what have I learned by these observations? On up days when I needed to buy a call debit spread to stabilize my trade, I used to wait for a small dip, thinking that prices would decrease, only to find that I'd bought an expensive spread after all. I soon learned that what I most needed was neither a small dip nor a breakout, obviously, but a small sideways movement, perhaps after a small dip or after a small breakout. Sometimes I could get my best prices for my hedging call debit spreads at those times. Markets don't always deliver those sideways movement, of course, so this information has not always proven utilitarian. However, by being aware that none of these effects works in isolation and then observing how prices change in real life, over and over, you can avoid more ugly surprises.

I watched an interesting video presentation on the brain the other day. During the course of that presentation, the researcher said that there's now so much information that doctors are required to process that they're trained on how to access needed information rather than expected to memorize all available treatments and medications for all known conditions. That's the idea here, too: you don't have to memorize each possible permutation of the Greeks of option pricing when trading options.

Many traders like the adrenaline rush of trading lots of different types of trades on lots of vehicles. In some cases, they feel safer not having all their eggs in one basket. However, there's something to be said, too, for trading the same set of vehicles and same set of strategies at least long enough to familiarize yourself with how they behave in a changing implied volatility environment.

Linda Piazza