This is an important, basic two-part post for rookies and anyone who wants to learn about using 'the Greeks' to manage the risk of an option position. Part I.
Each Greek does its own thing
In your example, the position delta is -59, and that translates into an expected loss when the stock moves higher by one point. I mentioned that the delta is not a constant number, but changes as the stock price changes. It's gamma that measures the rate at which delta changes.
Your position has -3 gamma. In terms you an apply to managing the position, that means:
- If the stock moves lower by one point, you gain 3 delta. Negative gamma works against you. Thus, you get shorter on rallies and longer on dips. Positive gamma works in your favor
- If the stock price moves one point lower, the position delta becomes -56. If the stock moves one point higher the position delta becomes -62
- Even that is an approximation because gamma is not constant. It's rate of change is measured by a different Greek. For the vast majority of trades made by individual investors, it not necessary to be concerned with such details. Professional traders, who seek every possible penny in edge and take extraordinary caution to trade as 'Greek neutral' as possible, pay careful attention to these Greeks
- More sophisticated traders also measure the rate at which change in volatility affects gamma. To learn more about the less frequently used Greeks, this Wikipedia article is a good place to start. But it's not necessary for us to delve that deeply into how options are valued
You begin the day short 59 delta. When the stock rallies by one point, the -3 gamma tells you that the new delta should be -62. Be careful with this next sentence; it's not tricky: Thus, on average, you were short 60.5 delta over that one point move (59 at the beginning and 62 at the end). A better estimate of the real world loss is $60.50, rather than $59.
Your position theta is 14. That should translate into a one-day profit of approximately $14 as a result of time decay. As you probably already know, theta is not constant. It accelerates as time to expiration decreases.
So, if you lose money ($60.50) on a one point rally, you can anticipate that the real lose may be $14 less, or $46.50 due to the effect of positive theta.
If the implied volatility changes, the vega component of your position results in a change in the daily profit and loss.
Bottom line: The Greeks provide a
reasonable estimate of risk – or how much to expect to make or lose when
the market moves. Many Greeks interact, so the final result cannot be
Even if you were able to be that accurate, the real world pricing of options (the option price (called the 'mark') that represents the value of the options in your account) can vary from day to day for random reasons.
Don't drive yourself crazy trying to get an exact handle on profit and loss possibilities. Look at the bigger picture. If a certain event (stock moves by 7%, for example) results in a predicted loss of $100, it does not matter if the loss is $105. What must concern you is being aware when a loss that's too big to handle may occur (perhaps when stock is up 12%) – and taking action to reduce the effect of such an event. That's referred to as adjusting a position.
Clarification: If that 12% move is dangerous, you may decide not to do anything right this moment to reduce your exposure to loss. But, if the stock creeps higher, at some point you cannot continue to close your eyes to a dangerous possibility. Making a small change to your position can be a good way to reduce your potential loss.
There are no hard and fast rules. The purpose of this two-part post is to be certain you are aware of how useful the Greeks can be in helping you manage portfolio risk.