Option Greeks, must-knows for efficient trading

Positive delta means option premium will rise and fall with the underlying index or stock.

We all know that the option premium is what makes us money if our price forecast on the stock or index goes right, however, when we trade options, we are forced to trade two more things.

1 Strike Price: Same stock’s calls and puts have various strikes to choose from

2 Time: Options are time-bound instruments (up to the expiry date)

While the price action of a stock or the index whose option we are trading is supreme, both of the above-mentioned factors impact the profitability of the trade.

To ensure that we get the most out of our forecast, we need to have an option that has the two factors in the right place. Out of the many, two major Option Greeks help us estimate the possible impact and choose the best possible option to trade.

1 Strike price impact estimated by delta

Delta is the rate of change of a strike option price with respect to the price of the underlying. Deltas can be positive or negative. A positive delta means the option premium will rise and fall with the underlying index or stock. A negative delta means the option premium will fall with a rise in underlying and vice versa.

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Deltas range between -1 to 1. A bullish view can best be played with delta around 0.5 and bearish with delta around -0.5. These strike prices are generally closer to the current market price of the underlying stock or the index.

Input from delta is positive delta for bullish trade and negative delta for bearish trade. Secondly, delta should be further away from 0, which means 0.6 will have more profit from the same movement of the underlying versus 0.4. So, if I am aggressively bullish, I will choose 0.6 delta strike. If I am a little conservative, I will choose 0.4 delta strike.

Time impact estimated by theta

Theta measures the rate of change in an option’s price relative to time, also referred to as time decay. Theta values are negative in buy option positions and positive in sell option positions. Theta has the same property for both call and put.

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If we know the Delta, we have a possible rough impact of price forecast on the option premium. For an option buyer, while this will be positive, the passage of time will be a negative factor. Knowing Theta along with Delta will help to know if the forecasted price in an expected time will make money.

Example:

Underlying stock = 100

100 CE = 3 with Delta = 0.5, Theta = -0.25

Our forecast: Stock will go to 102.5 in two days

Approximate Profit from Price Move Impact = 0.5 X 2.5 = 1.25

Approximate Loss from Time Impact = -0.25 X 2 = -0.5

Approximate Net Impact = 3 + 1 .25-0.5 = 3.75

We make similar calculations for a few more strikes and figure out whatever works best and choose it.

Since both theta and delta will change with time and change in price, the end result could be better than 3.75. But here even with the worst estimates, we can make a choice that sets us up for a more efficient option trade.