Options Trading Basics Greek Graphs Tell the Story of Call Strategies Understanding of the options greeks allows you to visualize and estimate the potential performance of a call options trade. By Ryan Campbell February 8, 8 min read 8 min read Photo by Call options are complicated because there are a lot of moving parts.
Of course, these changes affect a call seller differently than a call buyer. The options greeks help option traders estimate how an option will change value based on changes that take place over option delta chart life of the option. However, this not only changes an option's value due to the underlying having a price move, it also happens as a result of the march of time, and other changes.
An options premium consists of intrinsic and extrinsic value. Intrinsic value of in the money options is the value an option has only because of where the underlying stock is right now, at expiration, an option's value is zero. Intrinsic value is calculated by taking the difference between the strike price and the current price of the underlying.
You may remember that options with intrinsic value are in the money and options without intrinsic value are out of the money.
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Extrinsic value is the difference between the call premium and the intrinsic value. Extrinsic value is made up of time value and implied volatility. Notice in Figure 1 how the extrinsic values are highest near the at-the-money option. The greeks help traders understand why an options premium changes. The example used is for illustrative purposes only. Not a recommendation of any security or strategy.
Past performance does not guarantee future results. There are four major greeks: delta, gamma, theta, and vega.
FRM: Option delta
Delta and gamma deal mostly with the price of the underlying security, whereas theta and vega deal with the extrinsic value. For example, if a call option has a option delta chart of.
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Notice the purple line in Figure 2. This is a graph of the change in delta for a call option. The purple line includes both intrinsic and extrinsic values.
The green line includes only intrinsic value. A delta of 1 on the y-axis is equal to 1, Of course, those big moves cut both ways, so beware. Previously, we observed that the ends of the purple curve climbed at a slower rate.
Greek Graphs Tell the Story of Call Strategies
The middle of the curve is steeper, which reflects a higher rate of change. The rate of change is what gamma measures.
Now, look at Figure 3. Notice the purple line swells in the middle and is flatter on the ends. This reflects changes in the delta curve. Delta can only rise to a value of 1, so delta will grow at a faster rate when the option is at the money or nearly at the money.
These two curves provide insight as to why extrinsic value is the highest when the option is at the money. When an option is at the money, it has the highest risk to the seller.
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Often the seller is a market maker. Option delta chart extrinsic value absorbs some of the price movement. The green gamma line shows how sensitive delta is when extrinsic value is a non-factor. So, as extrinsic value is reduced, gamma becomes a bigger factor. Theta Theta is our first greek dealing directly with extrinsic value. It measures how sensitive an option is to time decay. Remember, time decay works against option buyers and favors option sellers.
Figure 4 shows theta is highest for at-the-money options and lower for out-of-the-money and deep in-the-money options. Earlier we observed that the biggest changes in delta and gamma, and, by extension, the options premium, occur when the option is at the money. For option buyers, the deck is kind of stacked against them because they have to overcome the extrinsic value that is working against them, in other words, time decay.
Option sellers can get the most extrinsic value by selling at-the-money options. However, they have a higher likelihood of assignment by doing this. So, they need to reconcile this risk by either accepting assignment or reducing the likelihood of assignment by selling out of the money for a smaller premium.
Vega Vega measures how sensitive an option is to changes in implied volatility. Figure 5 shows that when the option is at the money, it has the highest sensitivity to implied volatility. Implied volatility can rise and fall independent of price movement; however, it commonly rises when price falls. This means the curve below can shrink and grow. Notice how the green line is flatlined on the bottom of the chart.
Vega option delta chart highest at the money but shrinks as price pulls away in either direction.
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.
So, what does this tell us about call strategies? In fact, if a trader bought an out-of-the-money option, she would benefit from both the rising price and the rising implied volatility if the stock moved in her favor.
Buying out-of-the-money options is a strategy with option types and properties low probability of success.
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An option seller who sells at the money will benefit if the implied volatility drops, but will hurt the most if the implied volatility rises. Therefore, a seller may benefit most by selling when implied volatility is high and option delta chart falls.
Conclusion By graphing the greeks, we can draw a few conclusions. First, long calls have great potential if the stock appreciates, but they also have risks to keep in mind like all options strategies because of the difficulty of anticipating several variables.
Delta and gamma help you understand the price movement of options when the price of the underlying increases. Watch theta and days to expiration as time works against a long call position. Also, be aware of implied volatility because when it's higher, premiums are also higher. Unlike long calls, short calls or selling calls have opposite effects for theta and vega. As the time goes by theta is in your favor and high implied volatility means you will be able to receive bigger premiums for a short call.
However, you have to balance the risk of assignment with the option delta chart of premium you wish to sell. At-the-money options offer the highest extrinsic value and benefit the most from falling implied volatility. But, they have a high risk of assignment and high vega risk, so a common practice is to sell out-of-the-money calls.
Now that you have a better understanding of how options prices work and how greeks help you manage the different portions of a premium, you can build and plan your options strategies accordingly.