Know Your Greeks:
Delta — defines the amount an option price is expected to move for any $1 price change in the stock. For example, if an option had delta of +.25, then if the stock moved up $1, we’d expect the value of the option to increase by 25 cents (all else being equal). When putting on directional bets, you want to make sure there’s going to be enough delta in the position to make sure the move is worth it to your bottom line.
Gamma — defines the rate of change of the delta per a $1 move of the underlying. If gamma is +.15, and delta is +.55 and the stock moved up $1 from here, then the delta of the stock would then increase to +.70 (the previous delta plus the gamma). When employing credit spreads or delta neutral spreads, you want to be aware of gamma. Too much negative gamma means your position during a big move could quickly turn into a losing trade for you.
Theta — defines how much the option position will change in value each day. When you are net long options, your position will likely have a negative theta, meaning all else being equal, your position will lose a little bit each trading day. Conversely, traders who are net short options will have a positive theta position and can expect to make money each day, assuming nothing else changes.
Vega — the vega of an option expresses the change in the price of the option for every 1% change in underlying volatility. If you’re long vega, your position P/L will benefit from a rise in volatility, if you’re short vega, your P/L will lose in a rising volatility environment.
Common Words or Phrases Used at All Star Options:
Credit — the amount of money you collected at trade initiation when effecting a short position, or the amount of money you received when closing a long trade.
Debit — the amount of money you paid to purchase a new long position, or the amount of money paid to close an existing short position.
Defined Risk — This is a situation where you know precisely the maximum amount of money you can lose in any trade or spread. For example, in a long call, the most you can lose is the price you paid for that option, no matter how far the underlying has moved. Defined risk is a common character of many (but not all) debit spreads and short vertical spreads and short Iron Condors.
Delta Neutral — This is a trade that is put on when one doesn’t care which way the market moves as long at makes a large move eventually (when long a straddle, for example), or hopes that it doesn’t move at all (when short an Iron Condor, for example). “Neutral” refers to a near zero delta position at trade initiation where a position isn’t expected to gain or lose too much with minor moves in the underlying.
Expiration — All options have a date where they will cease trading. If you are holding in-the-money options at expiration, you will either want to close them before the end of the last trading day, or you will likely be assigned a corresponding stock position (long stock in the case of long ITM calls, short stock in the case of short ITM calls, long stock in the case of short ITM puts, or short stock in the case of long ITM puts). Out-of-the-money options will expire worthless and you don’t need to do anything.
Fair Value — options often times have wide bid-ask spreads, especially in percentage terms. For example, an out-of-the-money call option might be bid 25cents and offered 50cents. The offer is 100% higher than the bid! In situations like this, we don’t like to buy on the offer or sell on the bid, that’s just crazy. Instead, we’ll be looking to get executed somewhere near the mid-point of the bid-ask spread. And that mid-point price is often what’s referred to as fair value. So in this example given, the fair value of an option with a bid-ask spread of 25 x 50 would be approximately 37.5 cents. It’s a best practice to attempt to work limit orders at or near fair value.
In-the-money (ITM) — this refers to the strike price of the option relative to the current market price of the underlying. If a call strike is lower than the current stock price, then that call is said to be in-the-money and will hold value at expiration (value determined to be the price the underlying closes at expiration minus the strike price of the call). If XYZ stock is trading at $51. Any call strike $50 or below would be considered in-the-money.
Implied Volatility (or “IV” or “Vol”) — is represented as a percentage that indicates the annualized expected onerange for the stock based on the option prices. But don’t get lost in the math. IV is one of the biggest components of options prices. When IV is high, it is usually because options players are pricing in the risk of a big move (For example, an upcoming earnings report). When IV is low, it shows there is complacency with current prices and few are expecting any large moves to happen. We like to be buyers of options when IV is low and therefore options prices are “cheap” and we like to be net sellers of options when IV is high and therefore options prices are “expensive.”
Legging — As in “Legging into a spread.” In most cases when initiating a spread trade, all components of the spread will be executed together as one order. It’s just simpler to do it that way and usually more cost efficient. When legging into a spread, you’re executing each call and/or put strike separately, usually in an attempt to get better execution or to game some expected market fluctuations to your benefit. In most cases, I would advise against attempting this. Over the long run, it would likely be a net loser for you not worth the considerable effort.
Margin — This is the amount of money your broker will require you to put up to hold a position. In defined risk positions like a short vertical spread, this amount roughly equals the maximum you can lose in the trade. In undefined risk positions involving naked short options, your brokerage will require a higher amount to compensate for the “unlimited risk” potential of the position, and the brokerage will increase the amount required to hold the position the more it goes against you. Careful with naked short options!
Out-of-the-money (OTM) — this refers to the strike price of the option relative to the current market price of the underlying. If a call strike is higher than the current stock price, then that call is said to be out-of-the-money and will expire worthless at expiration. If XYZ stock is trading at $51. Any call strike $52 or above would be considered out-of-the-money.
Premium — This is the cost of admission. This is what you are paying over and above any “intrinsic” value of an option. For example, if a stock is currently trading at $50 and a $45 strike call is priced at $6.25, the premium in this option is $1.25 ($6.25 minus the difference between the current price of the underlying and the strike of the call). For out-of-the-money options, the entire value of the option is premium.
Roll (or “Roll up” or “Roll Down”) — this refers to closing an existing open options or options spread position and re-establishing a nearly identical trade but at new strikes or expirations. For example, if I was short a naked put and the market screamed higher, I might “roll up” my short puts to collect additional premium by buying to close the current put option and selling to open another put option in the same expiration series closer to current prices, resulting in a net credit for the two actions. Another common roll is closing a short option by buying to close when it approaches expiration and simultaneously selling to open the same strike option in a later expiration series, the net result of which is additional credit.
Spread — any position that involves a combination of two or more unique options.
Theta Decay — This describes the natural tendency for the value of options to lose a little bit of value every day. Traders should try to hold long positions in longer dated options as they tend to lose value the slowest. The closer you get to expiration, the more rapidly options prices decay.