Trying to predict what will happen to the price of a single option or a position involving multiple options as the market changes can be a difficult undertaking. Because the option price does not always appear to move in conjunction with the price of the underlying asset, it is important to understand what factors contribute to the movement in the price of an option, and what effect they have. Options traders often refer to the delta, gamma, vega and theta of their option positions. Collectively, these terms are known as the "Greeks" and they provide a way to measure the sensitivity of an option's price to quantifiable factors. However it's important that you realize the Greeks don't determine pricing, they just reflect what could happen in pricing changes for moves in stock, implied volatility, etc.
In our series here, “Understanding Delta, Gamma, Theta, and Vega.” Now, I know all these Greek words mean a lot to you guys and seem very confusing on the outside, but I promise you with this video, you'll understand completely how each of these affects the pricing of an option during the expiration cycle.
I’m going to get right into it here, and we’re going to take a look at a pricing diagram or a pricing table for an option and then look at the Delta, Gamma, Theta and Vega for this particular option, both on the call side and on the put side.
Okay, so what we have here is an options pricing table for the power shares of the QQQQ, and this is the ETF for the NASDAQ index, and it’s an exchange-traded fund that tracks the NASDAQ. It’s a really good option pricing table to look at, very, very liquid options that trade here on the Qs.
Now, just for reference, the Qs did close at 49.23 today, down about $.43, about 1% at the making of this particular video. Now, here is the pricing table that we’re going to look at today.
On the left side, we have the call options, and you can see right here that Delta, Gamma, Theta, and Vega are already listed for us, and then we have the put options on the right side of your screen here, and this is where Delta, Gamma, Theta, and Vega are already listed.
Now, these boxes in between here, the bid and the ask, that's just the price of the option, the bid, ask spread. The column down here in the middle is the expiration period. You can see here that we are looking at these particular options right now at a November 2010 expiration type option.
Now obviously, by the time you watch this video, this will probably be way beyond November 2010, but all of these guides and guidelines here work for any of the option pricing screens that you'll probably be looking at.
It’ll just be a different expiration period. Now, right next to the expiration period or the month of expiration is the strike price of these options. You can see we have $1 increments of these options.
Let's get into it here for the calls. Now very simply, we’re going to start with Delta. Delta is the incremental price movement in an option for a 1% move or a one point move in the underlying security.
You can see here that Delta right now for these 49 November calls is about .54. What that's telling you is that if the Qs were to trade up at one point that you would make about $.54 per option contract on this trade.
In this case, the $.54 equates to about $54 in value for this one option contract. Now, if we go over here and take a look at the put options, we know that when we trade puts, we want the underlying security or stock to go down.
You can see here that Delta for a put option is always negative because an increase in the stock price is not good for put option buyers. You can see here that for these 49 November puts, we have a Delta of negative .46, meaning if the Qs trade up by one point, we will lose about $.46 which equates to about $46 on this one contract for the put option.
That's a real big difference and can help you understand how options are traded. You can see that as we go out of the money for put options, the Delta becomes less and less. It's not equal across all fronts.
And really, the reason is that the further you get away from the current market with your options, the less a big move has as far as your profit margin, the less impact that it has.
You can see that on the [Unintelligible] corner view of the screen here, the same effect happens as you go out of the money for the call options. There is a lower and lower Delta.
Let's take a look at now Gamma for both the puts and calls. Now, if we’re taking a look at here the Gamma for the calls which are in this column right here, you can see that the Gamma for the calls is about .10.
Now, what Gamma is, is it's an always positive number for both calls and puts, and it's the rate of change of Delta. Again, it’s the rate of change of Delta. Both Delta and Gamma are constantly moving with the stock price in the market.
With a Gamma of about 10, it means that for every one point move in the underlying security, the Delta could change by an additional $.10. Let's say that the underlying security, the Qs goes up by one point. We could make in this particular instance for the call options about .54.
If it goes up another one point, we could make another .54, plus another .10. You can see it’s an additional step that we have on top of these options. If we go over here to the put options, you can see that Gamma is positive because it's the rate of change of Delta and has no effect on what Delta is.
If we look at these put options for the 49 strike put, you can see that if the Qs trade up by one point, we’ll lose $.46. If the Qs trade up by another point on top of that, we could lose $.46 once again, plus another $.11 on top of that. You can see it just compounds on top of itself until it's worthless.
The thing I wanted to point out about Gamma is that Gamma can be zero just like Delta as you start to get way, way, way out of the money options and this is real because these options have no chance of getting hit or a very, very slim chance of getting hit and therefore, they have no pricing effect on the options at all.
And you can see that this happened as well in the lower priced options for puts. As you get out here towards the lower end of the 40’s, there's a slim chance that these are going to be hit by November and therefore, the Delta and Gammas are very low.
Now, the last thing that we’re going to look at here is the options Theta. Now, Theta is the most important part of the pricing period for options for this one particular reason. It is always negative, meaning it's always working against you as an option buyer, but not as an option seller.
Now, you can see here naturally why we choose at Option Alpha to be in strategies that are focused and built on option selling, and that's because we have Theta working in our advantage or time decay working to our advantage. Theta is very simply the money that you lose every day because you get closer to expiration.
Now, Theta is going to be obviously bigger for those options that are closer to the current strike price and the current market price of the options and that's why you can see here that these call options right around 47 to 50 for these calls have a Theta of .02 versus these options that are a little bit more in the money or a little bit further out in the money.
Now, Theta is that one thing you can never, ever get away from. It’s always there, and it's always losing money. The big trick really, the big scheme or the big myth about options is that if the market moves higher and you have a call that you’re going to make money.
And that’s just not true. If the market moves higher, you could make money, but it has to move fast enough and quick enough so as Theta doesn't decay the value of that option.
Theta is just that little thing that’s eating away your value of your options slowly every day and then when you wake up at the end of expiration, you have no value in this option, and you have a big loss on your hands.
Again, Theta is something very important that you want to take a look at. Clearly, you can see that as you get closer to the current market, these at the money options, Theta becomes more and more powerful and eats away more and more at the value of the option.
Okay, so we’ve already covered Delta, Gamma, and Theta. Now, we’re going to cover the Vega of these options. Now, Vega is very, very simple and that's because the V stands for volatility. Basically what Vega is, is it’s the change in the option value for every 1% increase in volatility.
Now, we know that options have a finite life, so as the market becomes more volatile, there's more swings in the market, the market’s trading very irrationally and very rapidly as opposed to trading very, very flat.
The more swings that we have in the market, the more likelihood that those options are going to be worth more at expiration. You can see here that the Vega for every option is always positive unless you get to a finite outer end type out of the money options.
Now, it’s always positive because an increase in volatility can go both ways. It can be an increase in volatility that has a major selloff or an increase in volatility that has a major rally on our hands.
Obviously, just like everything else that we’re already learned about Delta, Gamma, Theta, the closer you are to the current market price or the current strike price, the more impact you'll have on Vega at your option price.
Now, this also works in reverse. If we have the volatility that is going down, then we can have these options become worthless just because the market is a little bit more flat and a little bit calmer.
In this particular instance, for these call options right here, you can see that the volatility premium is about $.7 cents per option. Now, if volatility were to increase just 1% and nothing else would change, at this point, you would make about $.7 because of the increased volatility in the market.
If volatility were to go down 1%, you would lose about $.7, assuming nothing else changes. I hope this has been helpful for you about Delta, Gamma, Theta and Vega and how they affect the pricing of an option.