New clients often think they have options figured out, but can’t figure out why they aren’t profitable. They throw an unbelievable sum of money at a particular option, and even though the market moves in their direction, their option wastes away. Gaining an understanding of some the mathematical variables that influence options pricing (known as the greeks) can help you become a more successful trader.
There are basically five factors that influence an option’s price, and there is a greek term that reflects each.
• Price of the underlying commodity
• The strike price
• Days until expiration
• Volatility of the market
• Interest rates and dividends (These mainly affect stock options and not commodity options, but can play a role in some instances.)
Delta – The Bang for Your Buck
Delta is the measure of how an option’s premium changes given a unit change in the underlying futures price. Basically, it describes the relationship between the futures price movement and the gain or loss on your option.
Delta tells you how much the value of an option will move based upon a $1 move in the futures market. The delta value for a call ranges between zero and one, often expressed as a percentage of zero to 100 percent. A put would have negative delta values, ranging from 0 to -100 percent. A zero delta would have little movement, while an option with a 99 or 100 delta would experience large price swings. For example, if we have a gold call option with a delta of 100, you would see its value increase by $100 if the futures moved up $1.
An at-the-money call option would typically have a delta of about 50 percent, and a put would have a delta of -50. That represents the probability the option has of expiring in-the-money at expiration. As an option seems likely to finish in-the-money, its delta will approach 1 or -1. If the delta changes, that means the bias of that market has changed. Many traders look at delta for hedging purposes, and to get an understanding of their risk.
Theta – The Race Against Time
All options lose their value as time passes, and theta is known as a measure of this time decay. Options with low theta values decay slowly because they generally have a long period of time until expiration. Theta is the constant enemy of the option buyer as time value leaves an option every day, no matter what direction the underlying futures price moves. Many times people pick up options, and then forget about them. Even though the market may have moved in their favor, theta can eat away at the option’s value.
You can see that if you buy an option 60 days out or greater, time decay isn’t much of a factor. But once the option approaches about 30 days or before its expiration, its value will begin to accelerate more quickly. At about the 45-day period on, I recommend making a decision on whether you want to keep any existing options positions you might have, or get out of them in case the market makes a sudden move against you. As you can see, you need to be responsible and watch your positions, even when trading options. You’d want to buy options with 60, 90, or even 120 days out until expiration, when theta is high. As time value is constantly eroding, theta is always negative.
Gamma – The Movement of the Movement
Gamma tells you the rate of change of an option’s delta, based on the movement of the underlying futures. The higher the gamma, the faster the change in delta, and the greater the impact on your bottom line. If you are long, and have a high gamma on your option, you can see the delta explode. You are essentially more net long, without modifying your position. Many people don’t bother to look at gamma, but I think it provides valuable information. If gamma really picks up and gets to higher and higher levels, it will cause delta to take off and you can wind up in a situation where your position can get turned around to put you on the side of the market you don’t want.
Gammas are greater closer to expiration. For example, when you have several months before expiration, a $1 move in gold won’t have as much impact on your gold option’s delta because the probability of that option finishing in-the-money is lower when there is more time for the market to move. As the gold futures price moves away from the option’s strike price, the gamma decreases, and as the gold futures move toward it, gamma increases.
Vega – The Fear Factor
Vega is basically the rate of change in the volatility of an option. It measures price movement through time, and is positive for both calls and puts because as implied volatility increases, the value of both puts and calls increase. The anticipation of large price swings increase the probability an option will be in-the-money at expiration.
Vega has played a major role in various markets ahead of key economic reports and events, such as Federal Reserve policy decisions, crop reports, oil and gas inventory reports, and in times of uncertainty or natural disasters. A major directional market move will impact vega, such as when a futures contract makes a limit-move.
You can get trapped buying options in times of high vega, because once the volatility comes down, the option’s value collapses. Gold and crude oil are markets that tend to be driven by emotions, and can make big moves. The price of the options becomes expensive—that’s the fear factor being priced in. People will pay whatever they have to pay because they feel they just have to have that option. Then the volatility simmers down and in just a few days, and the value of the option can collapse.
RHO
RHO measures the fair value of an option based on interest rate movements. As it tracks the changes in an option’s value based on movements in interest rates, it’s mainly a factor in trading Eurodollar or Treasury options. The majority of people buying put options in Eurodollars, for example, probably feel interest rates will increase. Unlike other greeks, RHO is greater for options that are in-the-money and decreases as the option moves out-of-the money.
I think it’s very important to understand some of these concepts and how they impact your bottom line. Understanding these greeks is a great way to improve your knowledge and become a more competitive trader. Feel free to contact me for further information about this topic, and how to apply these concepts to your unique situation.
Phil Streible is a Senior Market Strategist with Lind-Waldock. He can be reached at or 800-803-8037 via email at pstreible@lind-waldock.com.
Futures trading involves substantial risk of loss and is not suitable for all investors.
Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.
© 2010 MF Global Holdings Ltd. All Rights Reserved.
