How Much Option Greeks Do You Need to Know?

Question - How much option Greeks do you need to know to successfully trade options or to do your value investing with options thing?

Answer

The short answer is that it depends on what kind of option trading you're planning on doing.

There are some srategies where a more detailed understanding of the Greeks would be important, even required. Knowing what factors impact an option's price as well as how each of those factors affect and intersect with other factors, could be crucial in multi-leg spread type strategies where you have various long option positions and various offsetting short option positions.

But the good news is that you really don't need to know a great deal about the Greeks in order to employ the value investing oriented option strategies I lay out in The Essential Leveraged Investing Guide.

Basically, the only Greeks that I pay attention to are Delta, Gamma, and Theta, and even then, it's really not necessary to have more than a general awareness of the factor each plays in the pricing of an option. The value investing with options approach I take doesn't rely on complicated formulas or calculations.

The reason why Delta and Gamma are important is that they deal with how much an option's price is affected by price changes in the underlying stock.

If the underlying share price increases by a dollar, how much will the price of its call option increase (and how much will the price of its put option decrease)?

Well, that's going to depend in large part on the strike price in question. The deeper in the money an option is, the higher the Delta, or the greater the correlation between the stock price and the option price. Conversely, the farther out of the money an option is, the lower the delta is, and the smaller the correlation between the stock price and the option price.

For an at the money option, the Delta may give you only a 50 or 60 cents on the dollar correlation.

For something deep in the money, maybe you'll get 80 or 90 cents on the dollar move.

And for options far out of the money, the Delta could be very low, maybe a 5 or 10 cent move for each dollare move in the underlying stock's share price.

The expiration date also affects the Delta value. The closer you get to expiration, the more those in the money delta values increase and move toward a 1:1 ratio or relationship, and the more those out of the money delta values will keep moving lower and lower.

Gamma measures how much the Delta itself will change as the share price increases or decreases.

You can also check out this related article on net delta position, or net delta value, and how this metric can be used to measure the risk-reward of a calendar spread position.

The Takeaway

I'm not trying to dumb anything down, but I believe all you really need to keep in mind is the price of an option does not move in a direct 1:1 relationship to the underlying share price.

The option Greek I pay most attention to is Theta. Theta measures the theoretical daily decay of an option due to the passage of time. If, for example, the stock price remains flat, and none of the other Greeks change value in any way, then Theta will tell you how much value the option will lose that day.

One aspect of Theta that is crucial to understand is that the farther out an option is, the smaller its Theta will be. And the closer you get to expiration, the more Theta increases and - even more important - accelerates.

Theta is the primary reason why there are option sellers (and why the smart ones consistently make great returns). Writing puts and covered calls exploits the the decaying nature of options, and writing calendar spreads exploits the different levels and rates of Theta between long dated options and short dated ones.

Still, while Theta is hugely important (in the same way that oxygen is important), I'm not obssessed with monitoring the current Theta on all my trades or potential trades.

Sometimes it could be a factor in determining the optimum time to roll a short option position as you near expiration, but generally speaking, at least the way I trade options, what's most important about Theta is simply understanding what it is and why it can give you a great structural advantage on value oriented option trades.

Hope that helps/reassures . . .

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