To understand the basis of using options for spec trading, we'll briefly review the characteristics of options.
Call: A derivative of an underlying product (stock, futures) that gives you the right, but not the obligation, to purchase the underlying product at a certain price. You can buy or sell a call, meaning if you buy the right, you can purchase the underlying at a certain price in the future no matter where the price may go. For this, you pay a premium. If you sell a call, you receive the premium, but are obligated to fulfill the order no matter what the price of the underlying.
Put: A derivative of an underlying product that gives you the right, but not the obligation, to sell the underlying product at a certain price. Like a call, you can buy or sell a put, meaning, if you buy a put, you have the option of selling an underlying at a certain price. If you sell a put, you must buy the instrument from the put buyer at that price, no matter where the underlying price moves.
Strike price: The price at which you purchase your option. A strike can be in-the-money, which means it has intrinsic value because the current underlying price is above the strike (if it's a call) or below the strike (if it's a put). Or, it can be out-of-the-money, meaning it has no intrinsic value because it's above the strike price (in the case of a put), or below the strike (in the case of a call). An at-the-money option is when the strike price and current underlying price are equal.
Implied volatility: The difference between the current options price and fair value.
Time decay: The loss in an option's value as it draws closer to its expiration.
Delta: The most important and most commonly understood characteristic is delta, or the expected change in an option price relative to the change in the price of the underlying future. The delta of a put option ranges from -1 to 0, while that of a call option ranges between 0 and 1. By definition, the delta of a short future is -1 and the delta of a long future is 1. As a result, a ratio of options to futures (1/delta) is required to match exposures.
Gamma: The rate of change in delta is called gamma. The relationship between delta and gamma for a call option is shown in "Translating Greek." Delta increases most rapidly, and is exceeded by gamma as the futures price approaches the strike price; this relationship reverses after the strike price is exceeded. The gamma of a long options position, put or call, is always positive. A negative gamma on a position indicates the writing of insurance; most of the horror stories of sudden and massive losses in options trading can be traced to negative gamma.
Theta: Because options represent both a loan and a probability that a price will be reached by expiration, they decay over time. The rate of decay is called theta. Theta accelerates as expiration approaches, and this acceleration is greater for out-of-the-money options and at higher levels of volatility. The effects of volatility on theta are illustrated in "Theta's decay."
