So far we've discussed Delta and Theta. Gamma is next on the list. Gamma, simply stated, is the rate at which an option's Delta changes as the price of the underlying (stock, index, ETF) changes. Normally, the data provider on any given software package will express Gamma as the Delta's gained or lost for each one point/dollar change in the underlying.

The Delta will increase the amount of the Gamma when the underlying goes up and will fall the amount of the Gamma when the underlying goes down. If, for example, the $50 strike Call has a Gamma of .02 then for each point rise (fall) in the price of the underlying, the option will gain (lose) 0.02 Deltas. If the original Delta was 0.30 and the underlying moves up (down) one full point, then the new delta of the option will be 0.32 (0.28).

Gammas are always represented as positive numbers regardless of whether they are associated with a Call or Put. If we are working with either Calls or Puts we will always add the Gamma to the old Delta as the underlying rises, and subtact the Gamma from the old Delta as the underlying falls. When a trader is long in his option positions, whether Calls or Puts, he/she has a long Gamma position. When he/she is short options, he/she has a short Gamma position.

The Gamma has important risk characteristics that must be examined. If the Gamma is a large number, whether positive or negative, it indicates a high degree of risk. If the Gamma is a small number, whether positive or negative, it indicates a low degree of risk.

While there are volumes written on the subject of Gamma, we've discussed here enough to think about and establish a basic understanding of Gamma.

## Thursday, June 24, 2010

## Tuesday, June 8, 2010

### Theta

Theta is a greek value that represents the decay factor in an option. All options lose value (extrinsic value) as they move to expiration. The extrinsic value of ALL options will be 0.00 (zero) at expiration.

Theta is normally listed as a negative number and is the dollar amount that is lost each day. If the Theta is listed as 0.10 on a particular option, then that option will lose $0.10 in value per contract share each day. If the option is priced at $5.65, then tomorrow that option will be worth $5.55. A long option will be listed as a negative number and a short option position will have a positive theta. If the trader notices a large negative Theta value, then this will represent a high degree of risk with respect to time decay.

With respect to Long Directional Calls and Puts, Theta can be viewed as a friend instead of an enemy if attention is paid to how much time is purchased up front and when the trader exits the trade on the back-end. Generally, if the trader if buying Calls or Puts, then they should buy 4-6 months of time and if they are still in their positions at approximately 60 days prior to expiration, then it is suggested that they exit. The curve of Theta decay becomes a very steep slope at 30 days and so to avoid an emotional decision, it is best to exit at around 60 days prior to expiration.

For the trader that shorts a position, Theta is a friend, not an enemy.

Next time, we will talk about Gamma. Remember that a large positive gamma correlates with a large negative theta, and a large negative gamma correlates with a large positive theta. We'll discuss this and other aspects of Gamma in the next post.

Theta is normally listed as a negative number and is the dollar amount that is lost each day. If the Theta is listed as 0.10 on a particular option, then that option will lose $0.10 in value per contract share each day. If the option is priced at $5.65, then tomorrow that option will be worth $5.55. A long option will be listed as a negative number and a short option position will have a positive theta. If the trader notices a large negative Theta value, then this will represent a high degree of risk with respect to time decay.

With respect to Long Directional Calls and Puts, Theta can be viewed as a friend instead of an enemy if attention is paid to how much time is purchased up front and when the trader exits the trade on the back-end. Generally, if the trader if buying Calls or Puts, then they should buy 4-6 months of time and if they are still in their positions at approximately 60 days prior to expiration, then it is suggested that they exit. The curve of Theta decay becomes a very steep slope at 30 days and so to avoid an emotional decision, it is best to exit at around 60 days prior to expiration.

For the trader that shorts a position, Theta is a friend, not an enemy.

Next time, we will talk about Gamma. Remember that a large positive gamma correlates with a large negative theta, and a large negative gamma correlates with a large positive theta. We'll discuss this and other aspects of Gamma in the next post.

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