Matt Comyn, CommSec

The process of pricing options is indeed a complex subject given there is a number of variables which influence the value of an option. Trying to predict the price of an option as the underlying share price changes can also be a cumbersome task.

However, as option traders we have access to measurements which allow us to analyse the sensitivity of the option price to quantifiable factors – what we mean is, any change in one of the variables can be easily justified in the option price. It is important we understand what these variables are, and how the value of our option will change over the course of its life.

To help us determine changes in option prices we look at measurements such as the delta, gamma, theta and vega. Collectively these terms are known as the “Greeks” and each can be defined as follows:

Delta: Provides a measure to the sensitivity of the option price to movements in the underlying share price.

Gamma: Provides a measure of the delta’s sensitivity to movements in the underlying share price.

Theta: Provides a measure of the options sensitive to time decay.

Vega: Provides a measure of the options sensitive to changes in the volatility of the underlying share price.

The level of importance placed on each of the Greeks will vary amongst option traders, however it would only be the negligent options trader that would ignore the importance of the Greeks entirely.

I would like to emphasise the importance that option traders need to have a clear understanding of delta. One particular point I would like to highlight is this; traders need to acknowledge, although deep out of the money options are cheap, they only have a very low delta. This means there needs to be a large favourable share price movement before the option price appreciates. This fact is too often ignored by the novice trader.

A common mistake by inexperienced option traders is that they have difficulty managing the effects of time decay as measured by Theta. It is important to understand options are a wasting asset and the time value component of an option decays over its life. As a rule of thumb, one-third of the time value component is lost in the first half on the option life, and the remaining two-thirds lost in the second half of the options life. You may consider time decay similar to an hour glass - the sand drains from the top half into the bottom half at an increasing rate.

By simply being able to comprehend the Greeks an options trader will find themselves with a much clearer view when it comes to selecting and trading the appropriate option, given their market outlook. I would encourage anyone considering trading options to do their research and gain an understanding of the Greeks. Acquiring such knowledge will hopefully result in more sensible trading decisions.

By Matt Comyn, General Manager, CommSec

Disclaimers: The views expressed in this article are those of Matt Comyn, a representative of Commonwealth Securities Limited (CommSec) ABN 60 067 254 399 AFSL 238814 and is not intended as general advice.