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Keep Your Options Open

InvestorEducation / Options & Warrants Sep 22, 2009 - 01:16 PM GMT

By: Charles_Maley


While everyone has a right to his or her opinion, the people who are informed have more of a right - BILL DIXON

My experience is that most people who trade options do not do very well. A major reason is that most option traders don’t know how options are priced. Without having a basic understanding as to how they are priced, it’s difficult to understand how, and why, they will change in value. This makes formulating good trading strategies practically impossible.

Before we can become good at understanding which strategies to implement, it’s important to know the basics. Just like stocks or futures, options are independent vehicles and trade differently than their underlying security. So, what makes the option value rise and fall? Options will basically track the underlying stock or future, but there are many variables in their pricing traders should know about. A way to help measure these variables is known as “The Greeks”.

“The Greeks” are really a series of calculations that measure risk/reward changes in the option price, with respect to changes in interest rates, time value, implied volatility and changes in the price of the underlying stock or future.

The four basic measurements are as follows:

1- The Delta is a measurement of the change that will take place in the option premium with respect to price changes in the underlying stock or futures contract. The values range from 0-100 where 100 would reflect 100% correlation to the underlying instrument. A delta of 50 would mean the option would move 50% to the underlying instrument. So if a stock or contract moved two points the option would move one point at a 50 delta. The delta is constantly changing with price changes in the underlying security.

2- The Gamma measures the rate of change of the delta. This is how fast the delta changes with movement in the underlying instrument. 

3- The Theta measures the rate of decline in the value of the option caused by the time decay. Options have specific expiration dates, and the closer we move toward that date, the more the option will decay in value. This assumes no movement in the underlying instrument or changes in volatility.

4- The Vega measures the rate of change in the option with respect to increases and decreases in volatility. As volatility increases the option price will tend to increase even though there is no change in the price of the underlying stock or future.  

Interest rates are always changing. Time does slip away. The prices of the stocks and futures do go up and down, and volatility is always changing. This is why it is critical to look at these “Greeks” and understand how they can help you formulate better trading strategies to buy “cheap options” and sell “expensive options”.

Click here to see a great summary sheet on 46 different commodities and their respective volatility ranges. Also on the link, click an individual commodity to see detailed analysis.

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Charles Maley
Charles has been in the financial arena since 1980. Charles is a Partner of Angus Jackson Partners, Inc. where he is currently building a track record trading the concepts that has taken thirty years to learn. He uses multiple trading systems to trade over 65 markets with multiple risk management strategies. More importantly he manages the programs in the “Real World”, adjusting for the surprises of inevitable change and random events. Charles keeps a Blog on the concepts, observations, and intuitions that can help all traders become better traders.

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