What are the Option Greeks?
Understanding how option premium is affected by stock movement.
One of the reasons most folks think options are risky is because a very large percentage of them expire worthless. Which if you buy options is not a good thing!
Another reason options are perceived to be riskier investments is simply because even if the stock moves in the direction you expected when entering the trade, you still may not know how much profit you’re going to make. You may even take an actual loss!
Options are the only asset class where you can not only be right directionally and lose money, but you can lose money even if the underlying stock doesn’t move a cent. This is because options have one thing no other asset has…extrinsic value, also referred to as time value. This is value, in addition to what it is worth intrinsically.
This would be like selling a stock trading at $160, for $164
Stocks don’t have extrinsic value. Stocks just have value. If today NVDA is trading at $160 a share, the price is $160 a share. The stocks intrinsic value is $160, no more, no less. If the stock goes to $165, you made $5 a share. If the stock drops to $155, you lost $5 a share. Very simple directional math.
However, an NVDA 150 call option, that expires in 60 days, has a premium of $20.40. While the option only has $10 of intrinsic value, it also has $10.40 of extrinsic value.
If the stock were to rise, we know the stock owner would see a profit, but how much would the 150-call option profit if the stock rose?
You can’t answer that question until you’ve answered a few unknowns, such as how much the stock rose, how long it took to rise, and what happened to the options implied volatility.
Now, most things that seem hard, or confusing at first, are only confusing until you learn how they work.
Directional option traders look at the option’s Greeks to determine the option’s price action based on where the stock moves, or even where it doesn’t move to! Once you learn the Greeks, how the option’s premiums move, things get simpler faster.
Let’s look at two of the Greeks to figure out an options premium based on a stock’s move:
- Delta- How much an option premium rises for every one dollar of stock movement.
- Theta- How much the option premium decays for every day of time that passes.
For example, the NVDA 150-call option has a Delta of .65, that means that for every dollar the stock rises or drops, the option only moves $0.65, or $65 per contract. (a single call option contract represents the right to buy 100 shares of stock). So, if someone owned 100 shares and the stock rose $1.00, they’d profit $100. However, with a Delta of .65, if the stock rose the same dollar, the 150-call option would only increase $65.
Just knowing the stock rose one dollar still wouldn’t give you the current premium unless you knew how long it took to rise that dollar a share.
Theta tells us how much the options extrinsic value (all the premiums value above its intrinsic value) will decay for every day of time that passes.
If the NVDA 150-call option has a Theta of 0.13, that means that every day that passes, the option will lose $0.13/share, or $13 per contract.
Here are two major effects of Theta on your option’s ability to profit:
- If the stock doesn’t move for seven days, the options premium would drop, decay, by app $0.84, (.13 x 7 days), resulting in a loss of premium.
- If the stock took eight days to rise a dollar, eight days of Theta decay at $0.13/day would totally offset the directional profit, resulting in no profit. If it took two weeks for the stock to rise a dollar, the stock buyer would still have a profit, but the call option would be showing a larger Theta loss than the Delta profit. In that case you’d be right directionally, and still be taking a loss.
In options trading, you not only have to be concerned with direction, and getting that right, you also have to be concerned with how long it takes to move. And this is separate from the options expiration date.
In future columns, we’ll look at Vega/implied volatility and Gamma’s effect on an options trade.
Options aren’t hard, but they are different. But once you understand the differences, and how to account for them, options can become very enjoyable to trade!
Obviously, the Greeks aside, every trade has risk, either on the directional move of the stock, or non directional based on the Greeks. If you’d like to learn about how options work in all markets, or learn more about The Pinnacle Institute’s supply and demand strategy, please go to our website and enroll in one of our workshops.