Like many things in life, options trading can quickly become complex. Especially when you throw Greeks into the mix…
When traders mention being “gamma-neutral” or “high-delta,” it’s safe to say they’re overcomplicating things.
The truth is that these strategies are useful, but not suitable for many individual investors. Implementing these strategies requires large amounts of capital and access to expensive data feeds. More appropriate for large hedge funds than everyday traders.
But while individuals don’t necessarily need to use these complex strategies, they can benefit from understanding the principles underlying them. Gamma and delta are both examples of options characteristics called Greeks.
As individuals, a high-level understanding of the Greeks is useful. And so, today and this Friday, I’ll give you a crash course in what each of the Greeks are, and how they’re used…
The Greeks are delta, gamma, theta, vega, and rho. Each defines specific characteristics of options pricing models.
The Role of Inflation in Rho
Today, I want to start with rho. It’s a fundamentally significant aspect of options pricing, despite its place in the alphabet. And it’s especially important to understand right now.
Rho measures how changes in interest rates will affect an option’s price. Obviously, this will be an important concept to understand as the Federal Reserve is expected to raise rates next year.
While the math is a struggle to comprehend, the results are simple. When rates rise, in general, calls will be more expensive and puts will be less expensive.
Those changes are related to how options pricing models work. And when understanding these models, it’s important to assume that a market maker is involved in every trade.
Market makers have one goal: to make money on every trade they make. They do that by limiting risk. So, when we buy a call, the market maker will offset the risk by trading shares of the stock, put options, and adjusting their cash balance. With the right combination of trades, they will make money delivering the call to us without accepting any risk.
Pricing models assume the market maker borrows money to complete the trades. Increased borrowing costs force the price of calls higher in the market maker’s formula.
For puts, the model assumes the market maker will short some shares of the stock and receive cash that can then be invested in short-term money market instruments. Since the cash offers a higher yield than it did with lower interest rates, the model provides a slightly lower price for put options.
The differences will be small at first. If short-term rates go up 1%, expect to pay about 3% more for calls and a little less than that for puts. As rates revert to normal, with short-term rates above 3%, calls could be 7-10% more expensive.
Rising interest rates may not have an immediate impact on how many contracts you trade. But they might make options selling strategies more appealing. This is something to start thinking about now since rates should start moving up within the next couple of months.
I started with rho because that has a practical impact on how we might trade options in 2022. Delta is another Greek with practical applications.
The Most Important Greek to Know
Delta might be the most important Greek for individual traders. Delta tells us how much we should expect the price of the option to change if the price of the underlying stock changes by $1.
Traders generally use delta to define their trading strategy, whether they realize it or not.
If the option is deep in the money, the delta will be 1 or very close to it. For example, if a stock trades at $100, a call with a $50 strike price is deeply in the money, as is a put with a strike price of $150. This means if the price of the stock changes by $1, the option will also change by $1. When the delta is 1, the option is simply a trade on the stock with less capital committed to the trade.
If the option is at the money, a strike price of about $100 for this example, the delta will generally be about 0.50. That means a $1 change in the stock price will result in about a $0.50 change in the price of the option. If the option costs $5, the option changes in value by about 10% for every 1% change in the stock price.
For an option that’s out of the money, the delta will be small, but the price of the option will also be small. If the stock trades at $100, the $150 call or $50 put will be far out of the money. A $1 change in the stock may change the price of the option by 5%. But the option will cost just a penny or two, so that change is significant in percentage terms.
Delta determines which option you should trade based on your strategy:
If you use options as a proxy for owning the stock, a delta near 1 is best.
If you use options as lottery tickets hoping for a big payoff on a small trade amount, low delta options are best. Low delta options are also great for insuring your portfolio against the risk of a significant market decline.
If you want a balance between risk and reward, deltas near 0.50 are usually preferable.
On Friday, we’ll resume our discussion on the Greeks with gamma, vega, and theta.
Michael Carr, CMT, CFTe
Editor, One Trade
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Chart of the Day:
(Click here to view larger image.)
I woke up to a nice surprise this morning… All my saved lines and indicators on TradingView were wiped clean. I guess this is their way of welcoming me to a premium membership!
Frustrating. But, it also gives me the chance to wipe the slate clean and look at things from a fresh perspective.
With that in mind, allow me to continue sounding the alarm on stocks, and specifically today the SPDR S&P 500 ETF (SPY).
From a purely technical perspective, things don’t look amazing here. SPY has faked out a reclaim above the long-term support line and appears to be breaking down below it once again. The last time that happened, SPY fell about 4.5% in a few weeks.
A fall like that today would put us right in the middle of the yellow trend channel I highlighted above. So, I’m not calling for a devastating crash here. With stocks moving straight up for pretty much all of October, a correction is necessary. And that zone is a good consolidation area.
Break the $426 level, and things get a lot more scary. But I doubt we revisit that, with seasonal strength at our backs.
Taking profits on equities is prudent here.
Managing Editor, True Options Masters