Price Behavior, Greeks, and the Protective Put
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Dan Passarelli MarketTaker .com |
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The behavior of option prices isn’t always intuitive. Unexpected profits or losses are often realized to a trader’s delight or chagrin. This can be frustrating—especially when using options as a hedge. A working knowledge of, what is known as, “option greeks” can help a trader better understand the behavior of option prices.
Take the quintessential options “insurance policy”—the protective put. Buying a put option gives one the right to sell 100 shares of the underlying security at the strike price. This right is enjoyed until the option expires. Those who are new to options have been trained (and rightfully so) to consider how this position will perform if held until expiration given various changes in the price of the underlying—in other words how to draw a P&(L) diagram.
For example, given a long stock position of 100 shares purchased at $50 a share and also 1 3-month, 50-strike protective put purchased for $2, a P&(L) diagram such as this can be drawn:
The dotted line represents owning the stock outright. The red line represents the protective put position (long stock and long put). If this position is held the entire 3 months—until expiration—and the stock is below the option’s strike-price of 50, the maximum loss is set at $2. Why? The 50-strike put can be exercised. The stock that was bought at $50 a share will in turn be sold at $50 a share—a scratch. Only the $2 premium paid for the put is sacrificed. If the stock is above the strike at expiration, the long stock is retained and the put expires worthless. Here, the stock must increase by $2 to cover the cost of the put for the position to break even.
This is a fairly straightforward and useful analysis for this type of option strategy. It does, however, have limitations. What if the adverse stock move occurs prior to the expiration date? How effective is this 3-month protective put after only 1 month of time passes? After 2 months? In order to answer these questions, traders need to use a different type of tool for analysis. Option “greeks” can help traders gauge how an option’s price is likely to behave, given certain changes in the marketplace occurring prior to expiration.
Option Greeks
Of the factors that can affect an option’s price, the most important are direction, time and volatility. The greeks are units of measurement of incremental changes in an options price given a unit change in one of these 3 parameters. The greeks corresponding to these parameters are delta, theta and vega, respectively.
Delta is a numerical representation of how much an options price is likely to change, given a change in the underlying. Delta is stated in percentage terms. For example, an option with a 50-delta will increase or decrease by 50% of the movement of the underlying stock as the stock moves. So for example, if a stock increases by $1, the 50-delta call will increase by 50 cents (the 50-delta put will decrease by 50 cents).
How can a trader use this information in the real world? Deltas and the other greeks can be found from many sources. Ultimately, they are an output of an option-pricing model. There are many option trading software packages that have option-pricing models embedded within that will calculate these figures. Greeks can be found on various option related websites and from on-line broker’s web pages.
Theta measures how much an option’s price will change, given the passage of a unit of time. As time passes and the useful life of an option decreases, so does its value in monetary terms. Generally, this unit of time is expressed in 1-day increments, although, it is sometimes expressed in other units, such as 1 week. So, if an option has a theta of .05, after 1 day of time passes, the option is likely to decrease in value by .05 (or 5 cents), given all other factors—direction and volatility—remain unchanged.
Lastly, vega measures how much an option will change in value given a change in the volatility component of an option’s price, implied volatility. Implied volatility is an arbitrary input into an option-pricing model that reflects the supply and demand for options. When market forces cause this numerical input to increase or decrease, option prices react correspondingly. If an option has a vega of .10 and implied volatility rises by 1%, the option will tend to rise in price by 10 cents—again, all other factors held constant.
Direction, time and volatility are independent concepts; however, they all work together affecting an option’s value and should be considered for each trade. So in purchasing a protective put for an event that may occur at some random time between now and expiration (three months from now), the prudent trader should note the greeks of the option at the time of the trade.
Dan Passarelli is the author of the book Trading Option Greeks and the president of Market Taker Mentoring LLCTM. Market Taker Mentoring provides personalized one-on-one mentoring for option traders. The company website is http://www.markettaker.com.
Dan started his trading career on the floor of the Chicago Board Options Exchange (CBOE) as an equity options market maker. He also traded agricultural options and futures on the floor of the Chicago Board of Trade (CBOT). In 2005, Dan joined CBOE’s Options Institute and began teaching both basic and advanced trading concepts to retail traders, brokers, institutional traders, financial planners and advisors, money managers, employees of the SEC and Federal Reserve Bank, and market makers. In addition to his work with the CBOE, he taught options strategies at the Options Industry Council (OIC). Dan has been featured on television and radio and has written numerous articles in the financial press. Dan can be reached at dan@markettaker.com. He can be followed on Twitter.