Monday, February 23, 2009

Greeks

We can consider the Greeks as the language of options. They are commonly defined as variables used to quantify risk. Another word for “quantify” is “measure”, thus they are variables that allow us to measure risk. Simply put, the Greeks answer the question, “How Much?”. For example, if we buy call options we will lose money as the stock drops. The question is, “how much will we lose?” There is a significant difference between a long call position that loses $50 of value for every $1 the stock drops, versus a long call position that loses $5000 of value. For this very reason, it’s not enough to say I have a long call position and I know it will lose value if the stock drops. You must know how much value it will lose. We can look at the Delta of our position for this information.

Another example is that of time decay. Most option traders know that options lose value as time passes. Once again, it is insufficient to say that I own a call or put option, therefore I lose money as time passes. You need to know how much you lose. There’s a big difference between losing $1 a day and losing $200 a day. You can bet the way I manage a trade will differ depending upon how much money I’m losing due to time decay. We could also look at other examples on changes in volatility, but the above examples sufficiently illustrate the importance of assessing the Greeks. As option traders it is vitally important that we understand our risks for all our open positions, and really the only way to do that is via the Greeks. Stay tuned for an overview of Delta....

Tyler-