A to Z in Three: The Greeks
The ancient Greeks were master storytellers. Homer’s epic poem Iliaddescribes the famed city of Troy, a beautiful seacoast square which might still be standing had it not fallen for the ruse of the Trojan Horse.
The Trojan Horse, apparently left behind as a gift – a reward – was viewed with much skepticism. According to the poem, many inhabitants cautioned, “Somewhat is sure designed by fraud or force; trust not their presents, nor admit the horse.
Despite the warnings, the magnificent horse was wheeled behind city walls. But inside were hiding some forty warriors who swiftly destroyed the city in the middle of the night. Risk was there all along; it was just hidden from view.
Today, for option traders, the Greeks are still master storytellers but of a much different kind. Unlike the warriors of Iliad, these Greeks are simply letters. But they tell an equally important story – the story of risk hiding in your option positions. These Greeks can drop subtle hints or create huge red flags – but you must take the action. To understand the warnings, you must understand the five essential Greeks.
Delta, Gamma, Theta, Vega, Rho: They may all be Greek to you now but they’ll make perfect sense after taking our Greeks class.
The Greeks sound intimidating. They seem complicated. And it is for this reason that many option traders avoid learning about them. They convince themselves that the Greeks are nothing more than theoretical tools for academics and not of any practical use for investors and continue trading without understanding them. That’s the "ostrich strategy" and burying your head in the sand does not make the risks go away. It just ensures that you won’t see them sneaking up on your portfolio.
This Class Greatly Changes
This class greatly changes your perspective. The Greeks are simply little radars that detect and describe the potential big risks surrounding your option position or portfolio. They carry valuable information. They were designed for a reason. You’re better off with your head out of the sand facing the Greeks.
To intuitively understand the value of the Greeks, imagine that your boss just gave you a raise. That’s great news. You know your salary increased. But the burning question isby how much did it rise? It’s the size or magnitude of the increase that carries far more value than just knowing that it increased. And that’s the question the Greeks answers. The Greeks are sensitivity measures. They show us “by how much.”
The Greeks are Sensitivity Measures.
They Show us “By How Much.”
Here’s an analogy of why professional traders value the Greeks. Imagine that the price of gold is $500 and you think it will double over the next year. You don’t want to buy the gold futures contracts to avoid the unlimited downside risk so you search out alternative investments that are tied to the price of gold. I tell you that I have an investment that rises with the price of gold and has a maximum downside risk of $10,000. Do you buy it on that information alone?
My guess is that you wouldn’t without asking the key question: How SENSITIVE is this investment to changes in the price of gold? In other words, by how much will the investment rise for each dollar increase in gold? If you thought of that question, you’re getting the hang of the Greeks.
What if the investment was a $10,000 gold Rolex watch that contains one ounce of gold? If you’re right and gold doubles in price, that watch will theoretically be worth $10,500 next year (assuming all else being equal). That’s an increase of 5% for being correct that gold would double, which now doesn’t seem to be a good alternative.
But how would you ever have known just how good or how bad this alternative was without asking the question? Prior to asking the question, the investment may have sounded perfect. After all, it was apparently a low-risk way to profit from your outlook on gold prices. However, once the answer to its sensitivity was revealed, it doesn’t seem so hot. That’s exactly why professional traders ask the same question about their options. They get the answers by looking at the Greeks.
Most options have a fractional stock component to them just like the gold in our example was for the Rolex’s value. How much of a stock component is there in an option? That’s what the Greek “delta” tells us. If you buy an at-the-money option for example, its delta will be about 50. In other words, even though it controls 100 shares of stock, it behaves only like 50 shares – at least for the moment. That number will change for a variety of reasons and that’s why the Greeks are critical to understand.
A novice trader may know that his option doesn’t behave like 100 shares of stock. But a professional options trader knows that it is behaving exactly like 50 shares. Which do you think is better to understand?
Knowing that our option has a delta of 50 is great information. However, delta also changes as the stock price changes. Again, that’s great information but the better question is to ask is by how much? We get that answer by the Greek “gamma.” If our at-the-money call has a gamma of 5 and the stock rises by one dollar, our 50 delta option becomes 50 5 = 55. Gamma shows how much the delta changes for the next dollar move in the stock. The Greeks really aren’t so hard to understand.
Now that you’re getting the hang of it, let’s look at some other Greeks. An option’s value also changes with volatility. How sensitive is it to volatility? That’s what “vega” tells us. If the vega is 6 and volatility rises by one percentage point, our option’s price will rise six cents. So while a novice trader may understand that his option’s value will rise with volatility, the professional trader knows that it will rise six cents for the next percentage point increase.
Options also lose value over time. How sensitive are they to time? That is, how much value will the option lose with each passing day? That’s what “theta” tells us. If our option’s theta is 3 then we know that our option will lose three cents in value tomorrow assuming the stock’s price and volatility stays the same. A novice trader may understand his option loses value over time but is left wondering by how much and that's where the uneasy feelings come in. The professional trader knows the answer is three cents.
And because we’re dealing with money, options can rise and fall with changes in interest rates. The Greek “rho” shows how much. Fortunately, most options are not terribly sensitive to interest rates so there are, for all practical purposes, only four Greeks you need to know. That’s not so tough.
However, as you continue to learn about Greeks, you can get more detailed with the analysis. For example, the delta of an option can change with volatility. We find out how our delta will be affected with changes in volatility by looking at v-delta, which is one of five “second tier” Greeks. But once you’ve mastered the four essential Greeks, the second-tier Greeks become second nature. In the class, we will cover the five essential Greeks.
Without Understanding the Greeks, You Will Not Be Successful In The Long Run
If you don’t know the answers to these questions before trading an option, you may be successful in the short run. But in the long run, there’s a huge risk that, no matter how much research you’ve done, those shiny option picks turn out to be nothing more than fool’s gold.
If you find that your option investing is lackluster or if you feel uneasy about investing with options, it’s because you don’t understand the risks. Your instincts tell you there are risks but you cannot see them and that’s where the uneasy feelings come from. The Greeks add a lot of polish and make your investments shine.
If you’d like to sign up for this valuable course, you can find it in the bookstore (A to Z in Three – Greeks) for just $199. It’s a low-risk way to look inside the Trojan Horse.