Trading Options: Greek Power

I recently discussed five of 'the Greeks' which are used to measure the risk of an option position.  From the standpoint of risk management, trading stocks is far simpler than trading options.  Stocks have delta (100 shares = 100 delta), but none of the other risk characteristics associated with options.

That suggests that it's far easier to trade stocks.   All you have to worry about is whether the stock is rising or falling.  In terms of the Greeks, risk is measured in terms of delta.  If you own 300 shares, then you are long 300 delta.  If the stock moves two points higher, you earn $600.  That's the real number.  There are no other risk factors at play. 

When you are 300 delta long with an option position, and the stock moves higher by two points, it's not likely you will earn exactly $600.  Other factors – the other Greeks – are also in play.  It's possible to earn far more than $600, when you own positive gamma.  It's also possible that you have a position with large negative gamma, and by the time the stock moves two points higher, that gamma has turned your total delta negative – and you may lose money – despite beginning with a long position.

Thus, you may conclude that trading stocks is easier.  But that's being shortsighted.

The fact that option pricing is dependent on a bunch of risk factors may make it seem to be more complicated to trade, but you have so many more powerful methods for managing risk.  And that's what investing is all about: managing risk.  When trading, your goal should be to stay in the game and not incur large losses.  You can accomplish that by fine tuning positions so they make money when the stock undergoes a large move (long gamma), or when the stock trades in a narrow range (negative gamma, positive theta).  You can prosper when the market becomes much more volatile (positive gamma and positive vega) or when it becomes dull (positive theta, negative vega).

[ADDENDUM:  The Greeks allow you to measure risk.  That makes it easy to reduce any risk factor that makes it uncomfortable to hold the position.]

Options are exciting.  Options can be combined with stocks to create hedged (reduced risk) positions that are exposed to (or protected from) specific market risks.  You cannot do that when trading stock without options.


2 Responses to Trading Options: Greek Power

  1. Blue cat 05/24/2009 at 1:54 PM #

    Hi Mark,
    A question about Greeks. Is it possible to have a position in which one is short Theta (the position makes money as time passes if nothing else happens) and at the same time be “on the right side” of Gamma.
    What I mean by “on the right side of” is that if the market moves against you, gamma decreases so that the greater the adverse move, the smaller the delta per point.
    A simple negative example would be a short call at X, where X is OTM. As the market moves up towards X, Delta increases. (Gamma is positive, which is bad in this case.) Is it possible to have a position in which Delta decreases as the market moves against the position and yet the position is still short theta?

  2. Mark Wolfinger 05/24/2009 at 9:02 PM #

    1) Positive theta is a position that gains value as time passes. We speak of theta as postive or negative, rather than long or short.
    2) Gamma is always positive. If you own options you have positive gamma. If you sell options you have negative gamma. The gamma of your position calculated by adding the gamma of your longs and subtracting the gamma of your shorts.
    3) To be on the ‘right side’ of gamma, you must be long gamma. So, if the market moves against you to the upside, you must have positive gamma for the negative delta to decrease. (Or for the positive delta to increase).
    4) If gamma ‘decreases’ then a point is reached where gamma moves from positive to negative and begins to work against you.
    5) For all the normal positions we tend to trade, the answer is ‘no.’ Positive gamma and positve theta don’t go together.
    I suppose you can find exceptions and you can try by building a position with lots of gamma (buy near-term ATM options), but you must sell enough options to offset all that time decay, yet still continue to own positive gamma.