Options Trading with The Greeks – Delta and Theta

The ancient Greeks helped us in a number of ways, but they get a lot of credit for helping to invent much of what we use today in elementary mathematics. From this basis, our modern society has helped to create the tools that help us calculate risks and decide on prices for goods and services rendered. Among these tools for calculation, we refer to the Greek words of delta, theta, gamma and vega. These tools are affectionately referred to as “The Greeks.”

The basic concepts are simple and can be used by anyone helping to reduce the risk of a particular venture and maximize the profits that can be obtained in the transaction. The mathematics involved, however, can be intense.

Using “The Greeks” tools, you rely on common sense, which will suggest the price of an option. There are also determinants that will assign the underlying market price of the asset, the strike price of the option, the expiration time, the volatility and the short-term interest rates. When you combine all of these pieces of data together, you can see what the influences are on an option’s value in the marketplace.

For example, look at the strike price. The strike price is the specific price that is contractually agreed upon. This price is the exact amount at which the asset, for example a stock, would have to be bought or sold if the option was taken advantage of.

Let’s look at this idea using a specific stock purchase. If Microsoft, for example, were selling their stocks at $28.00 per share and there was an option available called the June 31 call. In this case, the “31” would refer to the strike price, not the date the option expires. The option in this case is “out of the money” because the strike price of 31 is higher than the current market price of 28.

The price of the option will be influenced by the difference between the strike price and the current market price. In order to determine the difference between these two numbers, you calculate the first Greek tool, the delta.

The delta is not the difference between these two numbers, but rater is the radio that compares the change in the strike price to the change in the actual market price of the asset. Delta will influence future calls. For example, if you have a delta of .7, every time the Microsoft stock rises $1, the call option can be expected to increase by $0.70 in relation.

As a trader, you don’t need to know how to calculate the delta, only how to use it to your advantage. If you have a good options software trading system, for example, you will see all four Greek tools, in addition to the price, expiration, etc. The closer the option is to expiration, the more the delta is apt to increase. If there is implied volatility, the delta will also change.

Theta is another Greek tool that measures the “time decay” of the option. The less time the option has on the market, the more the theta increases as it is a measure of risk and value within the option’s expiration date. As the expiration date draws closer, the premium price will decline at a faster rate and that change is reflected in theta.

         

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