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Options Trading - Blessed Are the Greeks - Part I

The Greeks have long been extolled for their extensive contributions to establishing elementary mathematics. It was the modern Greeks, however, who created the tools that aid options traders to quantify risk and calculate prices. Among these tools, one that rises above the others are the quantities known as "The Greeks." They are delta, theta, gamma and vega.

The underlying mathematics regarding this tool is quite complex, but the basic concepts are simple. They can be used by any trader as a method of measuring risk and maximizing profits.

The Greeks are founded on the basis of particular variables that affect the price of an option. Much of this is common sense. For example, the determinants are the underlying asset's market price, the option strike price, the time left to expiration, volatility and short term interest rates. This data is easy to acquire so it is a logical assumption that it plays a part in an option's value.

The strike price is a prime example. The strike price is the contractually specified price at which the asset would have to be bought or sold if the option were exercised.

If MSFT (Microsoft) was selling at $28 per share and the option considered was a June 31 call (the 31 meaning strike price, not the expiration date), the option would be out of the money because the strike price is higher than the current market price.

The premium, the actual price of the option, is affected by the depth of the range of out of the money the option is. The first Greek, delta, is a way of measuring this difference.

While the difference is not simple, the delta somewhat simplifies it by creating a ratio that compares the asset price change to the option price change. For instance, is the delta in the previous example was 0.7, for every rise of $1 in MSFT then the call option can be anticipated to increase by 70 cents.

It is not necessary for the trader to know how to calculate the delta; they only need to know how to use it. Most reputable trading software shows all four Greeks as well as the price, expiration and other details. Delta has a tendency to increase and the option nears expiration for those who are close to in the money. Implied volatility also affects Delta. This is often included in trading software as well.

Theta provides a measure of that is referred to as the "time of decay" of an option. All options have an expiration date and the closer it is the expiration date, the less likely it is that the market price will move in the desired direction. Therefore, theta measures risk and value.

To further the example, if the MSFT June 31 call was priced at $3 and the theta was 0.5, then, in theory, the value of that option would drop by 50 cents per day.

As the expiration of an option nears, the price for a premium typically drops at a faster rate. For example, an option that has two days before expiration, it is losing its value faster than an option that has three months till expiration. That change is what the value of theta reflects.

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