So, you’re new to options trading and you want to know what the Greeks are? Why do they matter?
The Greeks
Intro
Let me start with this, ‘ITM’ means In The Money, ‘ATM’ means At The Money, and ‘OTM’ means Out of The Money. So, when you buy an option contract, it is either ITM, ATM, or OTM. To quickly explain ITM, ATM, and OTM; let’s say that we take stock symbol TRIP. Say we are looking at Strikes for a TRIP call and we see that current stock price for TRIP is $28. An ITM option would be anything below a $28 Strike Price as the contract would be below the current stock price, thus the stock is said to be ITM. Now, let’s say you take a $28 Strike price, now you are ATM because your strike price matches the stock price. To select an OTM strike price, you would choose any strike price above $28 as those would be OTM compared to the stock price. The answers to pretty much everything you could ask on Greeks all depend on where your option is. The Greeks are Delta, Theta, Vega, Rho, and Gamma.
DELTA
Which is best? Delta — Higher or lower? — Neither is ‘best’. Though many people will argue this all day long, it really depends on your option. To explain…an OTM option will have a lower delta than one ATM, and the deeper you go ITM, the closer the delta comes to 1:1 with the underlying stock. Meaning: the value of an option deep ITM will increase or decrease at the same rate that the stock moves.
So, if the stock moves up 3 points, the value of your option will increase 3 points (assuming you have a call). Deltas ATM tend to be near the 0.50 value +/-. If the stock moves up 4 points, the value of your call only moves up 2. Options way far OTM can have deltas as low as 0.05 or lower. What’s the advantage of buying an ITM option over an ATM option and trying to get that 1:1 ratio? Truth is, there’s really no advantage. The cost of an ITM ratio that gets the 1:1 ratio will often be more than double the ATM option getting half the price increase (0.50 delta). So, why not buy 2 ATM options (for most likely cheaper than 1 ITM option) and achieve the same final result in profits?
The only real argument to buy a deep ITM option people will say that if the market moves against you, you’ll still have some value at expiration because it will expire In The Money and have value (called intrinsic value). But a smart investor would never hold a losing option like that and would most likely have hit their Stop Loss way before expiration. (There are more advanced techniques, but don’t worry about those now). So, if buying 2 ATM options to get the same result as 1 ITM option is good, why not buy 20 OTM options with a small delta to make that same profit?
And this is where theta comes in. Far OTM options are killed by theta. Their value “generally” will decrease faster than the stock will reach the options strike price. However, slightly OTM options, say 1–3 points away, can be a good buy if you’re anticipating a strong move in that direction. As a general rule, the farther OTM you buy, the more likely you are going to lose. In fact, another way to look at delta is, “whatever the delta is, that’s your chance that option will expire ITM with value.” So, a delta of 0.50, is literally a 50% chance it will expire worth something. An OTM delta of 0.10, is a 10% chance it will expire worth anything. Remember this if you’re ever getting into selling options.
THETA
Theta — Higher or lower? — THETA MATTERS!!!! In fact, it’s one of, if not THE MOST IMPORTANT Greeks to be aware of. Theta is the rate at which your option will lose value every day that goes by. So, let‘s say the stock is at 100. You buy an option ATM with a 100 strike price that expires in 30 days (so today, January 15th, you bought a February 15th option). You pay a price of 5.00 (5.00*100=$500) for that option, and it has a theta of 0.15. Tomorrow, if the stock closes the same at 100, your option will be worth 4.85, or $485, down $15, or the theta value. And that “theta decay” continues until the option expires on June 15th. However, theta doesn’t stay the same for the entire 30 days of the contract.
As we get closer to the option’s expiration, theta increases; meaning your option becomes worth less and less at a faster rate every day. But here’s what you need to know, the farther you are away from expiration, theta only increases a little. So, when you bought your February 15th option today, your theta was 0.15. Tomorrow it might be 0.16, the next day, 0.17. So, if the stock remains unchanged at 100, the option you paid $500 for goes down to $485 ($500–15), the next day $469 ($485–16), and so on. But as you get say a week from expiration, instead of theta decay getting bigger by 0.01, theta will increase by say 0.15 a day, then 0.25 the next, then 0.40 the next. If you Google “theta decay graph,” you’ll see it‘s not a straight line, but rather a curve that drops increasingly faster. It goes along flat, but then it starts to drop like a rock as the expiration nears. That‘s how the value of your option acts as it gets closer to expiration, it drops like a rock because theta grows bigger and bigger, faster and faster as it comes to its expiration.
Now, here’s something else you need to know. OTM options have higher theta decay rates than ATM options with respect to their value. Meaning, if you bought an option today with that same February 15th expiration date but OTM with a 0.20 delta for say $100, that OTM will be basically worthless (maybe have a 0.01 value) at like 7–10 days before the expiration date. An easy way to see this is to check the price of an option 15 points OTM on the SPY 30 days away from expiration. Then check the price for that same strike price 21 days out, 14 days out, 10 days out, 7, 5, 3, etc. and you’ll see the effects of theta. The difference in those prices is purely theta decay. If you ever get into selling options, theta decay is how you’ll make money (not counting the stock moving away from what you sold).
VEGA
Vega — Higher or lower? Vega matters! I’ll say this again because it is important, Vega matters! Vega is tied to the volatility of the market. It’s actually easy to understand. The more buying and selling and big price swings that occur (volatility), the higher the price of an option. The lower the volatility, the lower the price for that same option. Take that same ATM February 15th option that you paid $500 for. Last month, when the market was going crazy, that same 30 days from expiration option would have cost you $1,000! That‘s Vega. What you need to worry about with Vega is what‘s known as the ‘Vega Crush.’ If you paid $1,000 for that option and the volatility (Vega) dropped. What would that option be worth now, $500. The reverse is true as well though. If you pay $500 and volatility spikes, that option is now worth $1,000. Now, these two examples aren‘t likely real-world examples, but they illustrate the point.
What is the real world is Vega and the Cboe Volatility Index (VIX) and small intra-day type moves on the SPY (S&P) symbol. When the VIX goes up, the SPY goes down, but Vega also goes up. When the VIX goes down, Vega goes down, but the SPY goes up. So, let’s say the SPY is going down (Vega will be up and as a result option prices will be higher) and you correctly think it’s at the bottom, so you buy a call ATM to make money on the bounce up. When you buy your call, you see that the calls 5 points ITM are trading for $300 more, so you set that as your target price because you want to make $300. The problem is, the market moves up, the VIX and Vega go down and so does the price of options. So, you‘re right, the market moves up 5 points, but instead of your option being worth $300, it‘s only worth $250. That’s Vega Crush for you. There are trading strategies out there that practice selling options during high Vega and buying them during low. The information is out there about how to trade the Vega way, but I am not a fan of it.
RHO
Rho — Higher or lower? RHO is tied to interest rate fluctuations. They are essentially meaningless for the last 10 years or so, since rates have been so low and constant. Don‘t bother worrying about it. (Note: I personally remove this from my view)
GAMMA
Gamma — Higher or lower? Simply stated, gamma tells you if the market moves up (for calls) a point, and the rate the delta will increase will be at that gamma rate. For example, let’s say you bought an option with a 100 strike price, and the stock is also trading at 100, so your option is ATM, and it has a 50 delta, and a gamma of 0.04. Now the stock goes up to 101 and your option is now worth $50 more (the 0.50 delta). What the gamma is telling you is if the stock goes up another point to 102, your delta will now be 0.54 (0.50 delta + 0.04 gamma), because it is now deeper in the money, and as options get deeper and deeper ITM, their delta moves closer and closer to 1.00 or the 1:1 ratio with the stock move.
Now, in a high or low volatility market, the value of gamma might fluctuate slightly, but not enough to worry about. Truth is, Gamma isn’t really worth the time in the scheme of things. Worry more about where the stock is going to move and how far.
Conclusion
Which Greeks are most important when deciding to buy or not? Well, it depends on what you‘re planning on doing. Are you looking for a quick day trade? Then the only thing that really matters is delta, and even then, only in the sense of are you going to buy an ITM, ATM or OTM contract and how much money do you have to invest? Think it’s going up 5 points tomorrow? Maybe pick up a couple ATM +/- a point or two that expire in 3–5 days? If you’re looking for a 10 point move between now and the next 2 weeks, then you need to worry about Theta, Delta, and Vega. Maybe buy an ATM option but 45 days out so that you get a lower Theta decay.
Maybe… you could buy a vertical 30 days out, so you don‘t really suffer any theta decay, but now your profits are capped. Vertical spreads involve buying options at different strikes. So, with those scenarios in mind, the first thing you need to know is “What do you think the market is going to do, and when do you think it is going to do it?”
I tend to avoid swing trading for most contracts or trading long-term. The only thing I look at is the delta ATM +/- 1 point vs the cost of the option. Is it worth tying up say $500 more to get the higher delta at 1 point ITM vs what I’ll pay for 1 point OTM or at ATM. As a smart investor, that’s all I look at. If I was doing something more long term (2 weeks or more of swinging), then I’d be concerned if the stock is going to move enough to cover the price of my option.
Hope this helps! Thanks for reading! More articles on options to come. Stay tuned!
If you want to start trading, my opinion is that a cash account on Webull is a good starting option. Below is my link for a Webull referral.
https://act.webull.com/ie/XsHypGXnvHOT/weu/inviteUs/
