Gamma, the Change in Delta

It is time again for another lesson on options. Let me first apologize for the lack of updates recently; with final exams and the holidays I have been a bit distracted. However, that is about to change, so let's get started!

What is Gamma?

The Gamma of an option is directly related to the delta of an option. Gamma measures the change in the delta of an option as a stock moves up or down. It may sound confusing, but the basic application is relatively simple. If you have a call option with a delta of .5 and a gamma of .17 and the underlying stock moves up a full point then the delta of the option will move up to .67!

I know what you're thinking. "So, that's cool Spencer; I can figure out the delta of a stock while it's on the move… very useful…" Save the sarcasm. Gamma is much more useful than it first appears.

The Delta Hedge and Gamma

When you are short options you can have a complete hedge by owning the amount of shares equivalent to the delta. Say you are short one call option with a delta of .5. You can be totally hedged by simply owning 50 shares of the underlying stock, but what if the stock moves up or down? This is where the gamma comes in handy. By knowing what the gamma is you know how quickly your position can turn sour.

Delta decays with time, where gamma increases until expiration. Because of this, it is safest to be short options when there is a while until expiration. When expiration you want to be in a position where you maximize gamma, and if the price spikes in your direction you will be in for a good deal of profit!

Stay tuned for more on the Greeks!

Until next time,

Spencer Sundahl

Understanding Delta

It’s time to start talking about the Greeks. The Greeks are a set of analytical tools to help you build and maintain your options positions. You can find the various ‘greek’ values for an option online at your broker’s website, or at ivolatility.com. The first one we are going to talk about is Delta. So what is delta, and what purpose does it serve?

The Delta

Conceptually, delta is very simple to understand. For a call it is the percentage an option will increased based on an increase in the underlying security. And for a put it is the percentage (as a negative) based on a decrease in the underlying security.

For example:

You have a call option with a delta of 25%. The underlying stock increases in value by $1.00. $1.00 x 25% = $0.25. Thus, your option increases in value by $0.25! If the stock fell by a dollar instead of gaining, you would lose $0.25.

You have a put option with a delta of -25%. The underlying stock falls in value by $1.00. -$1.00 x -25% = $0.25. (Notice the negatives cancel each other out, thus making a positive gain for your option.) and so your put increases in value by $0.25! If the stock increased in value by a dollar, you would lose $0.25.

Practical Use of Delta

So aside from number crunching how much you might make in a day with your options why is delta so useful? Delta is a great tool because it allows you to create positions that are delta neutral. This means the delta of your position is 0. Delta neutrality is a strategy generally used when talking about straddle and strangles, which use a mix of calls and puts. Both of which are volatility trading strategies that we will cover in the very near future. When a position is ‘delta neutral,’ it will gain as much to the upside as it will to the downside. An important factor when creating a complex options position. Aside from this, delta is a great analytical tool to use to create a partial hedge. It is also very useful if you are trading the futures market.

Delta is a great asset to any options trader. Especially, one who is managing more complex positions than a long call or put. Despite Delta’s greater use for more complex positions, it is still quite useful for basic analysis as well. Next, we are going to talk about another of the ‘Greeks,’ the Gamma of an option.

Until next time,

Spencer Sundahl

A Week for the Greeks

This week at the Not-so-implied Volatility blog we're going to talk about the 'Greeks.' You might be wondering: "why do I care about a bunch of hairy men?" Luckily for us, hairy men have nothing to do with it! The Greeks are a set of analytical calculations for option positions! Here's the bunch of 'em:

• Delta
  
• Gamma
  
• Theta
  
• Vega
• Rho
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  

Five Greek symbols will make for a lot of learning, so make sure to stop back on by!

Talk to you soon,

Spencer Sundahl

The Calendar Spread

Last time we spoke I introduced you to volatility. Now after a break for the holidays, I'm going to teach you how to take advantage of it! Today, we're going to talk about a new option strategy that takes advantage of both rising volatility and time decay, called the calendar spread.

Just a Matter of Time…

So what is the calendar spread? And why is it a useful option strategy to know about? The calendar spread is an interesting strategy. In many ways it's a mix of writing a covered call and buying a call with a different expiration date at the same time. Let me break it down for you.

A calendar spread can be constructed with both calls and puts depending on your general opinion of the market or stock. However, for the sake of clarity we will only consider a spread involving calls. Because we are considering calls, we have an overall bullish opinion of the stock we are constructing the spread with. However, with a calendar spread we are neutral in the short-term. So what exactly does a calendar spread entail?

To create a calendar spread you buy a long-term option and sell a short-term option of the same strike price. The idea is that you will take advantage of the heightened time decay of the short-term option and make substantial profits when it expires (hopefully worthless.) After that time you can either close the position, or keep your long-term option (which you've now obtained at a nice discount), and let your view of the market take its course.

Another nifty feature of the calendar spread is how an increase in implied volatility affects the position. As implied volatility increases, the price of both calls and puts also increase. This increase in price has a larger effect on long-term options than short-term options, thus when this happens a calendar spreader benefits, and sometimes quite substantially.

Personally, I find the calendar spread an incredibly attractive strategy. Not only does it limit your risk exposure (your maximum loss is the amount paid to open the position), but it also allows for a very hefty profit. At times the shorter term option will expire and leave your longer term option with 100%+ in gains! What surer profit is to be had in the option's market than that gained from time decay?

Until next time,

Spencer Sundahl