From the June 01, 2012 issue of Futures Magazine • Subscribe!

Greeks: The what, why and how of options pricing

Options can be frustrating for new traders used to the two-dimensional movement of underlying stock or futures prices. Options are three-dimensional and their movements are based on more factors than the simple strength or weakness of the underlying. 

Thankfully, guidance can be found in pricing models and the Greeks. “The Greeks give option traders a realistic expectation of how an option price will change if certain factors in the market change,” says Jim Bittman, senior instructor at the Options Institute at CBOE.

Simply stated, the Greeks are a group of mathematical models that each help to calculate the theoretical value of an option. While advanced models may involve many more variables, here we will examine the five that are most important for novice options traders.

∆ (Delta)

Delta tells you how far the value of an option is likely to move based on a $1 move in the price of the underlying asset. Delta is expressed as a range between zero and 1.00. The higher the delta, the more closely the option value will follow that of the underlying. Delta helps temper a trader’s expectations of when the underlying moves.

Alan Grigoletto, director of education at The Options Industry Council, explains delta to new traders by likening it to walking with a child. “Imagine that I’m holding the hand of a small boy who is three years old. For every step that I take, he correspondingly can only take one-third of my gait. He’s an out-of-the-money option and only has a delta of 33,” he says. “Now imagine the boy is 10 years old. He’s now an at-the-money option. Now, for every step that I take, he can cover half my gait and has a delta of 50. Then as he grows up and becomes stock, or adult-like, for every step that I take, he moves at the same rate. He’s now a deep-in-the-money option.”

Options with higher deltas tend to be more expensive, deep in the money and close to expiration. “You get more bang for your buck, but you pay more bucks,” Bittman says. “The art of the business is matching up the amount that you are willing to risk for the so-called delta involved.”

Traders who want to risk less capital might buy out-of-the-money calls, but they need to know that the option is not going to move as fast as the underlying stock, and that the likelihood of it expiring in-the-money is low. So, while you risk less money, the odds of success are much lower. 

Understanding delta is helpful for traders using options to hedge a position because it tells you how many options you need to buy to fully protect yourself against moves in the underlying. Note that one equity option controls 100 shares of the underlying stock, while one futures option controls one futures contract. 

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