Trading options generate numerous types of risks, which go beyond what most investors can fathom. In general, the majority of option investors believe that an option buyer is subject to risking the premium that he/she paid for an option, where an option seller, is subject to unlimited risk, only protected by the premium taken in by the sale of an option.
Although these statement are true, the risk involved in options trading goes beyond these statement, and theoretical opportunity cost is also risked, and captured in derivatives of the underlying asset called “Greeks”
The Greeks of an option are the theoretical risk associated with an options positions. The major risks are the “delta”, which is the percentage of long or short position inherent within a call or put option. The “gamma”, which is the change in the delta relative to the change in the price of the underlying financial instrument. The “Vega” which is the change in the value of the option relative to the change in the price of implied volatility, and the “theta” which is the change in the value of the option, usually on a daily basis, relative to time.
The delta of an option is usually referred to in terms of percentage, and then that percentage is multiplied by the number of options or option on contracts to determine the exposure a trader has relative to a movement in the underlying asset. For example, if a trader purchased 10 Call options Comex Gold that had a strike price of 1240 when the underlying market for Gold was 1240 (with an expiration date, that was 30 days from the current date), the delta would be approximately 50%. This would mean that the trader had a theoretical underlying position of long five contracts of Gold.
If Gold prices increased by $10 dollars per ounce, then the trader would theoretically make $50 dollars on the trade, if everything else remained constant. For a put option, using the same values as discussed in the call option above, a trader would be theoretically short five contracts of gold, and would lose $50 dollars on the same position if the market were to move higher by $10 dollars per ounce and everything else remained constant. There are numerous ways a trader can capture this type of risk without selling out of a long call option is the market where to move higher. One of the ways a trader can capture a market move in his direction would be to “delta hedge”
Delta hedging is the process of taking profit or mitigating losses by using the underlying asset to remove the theoretical risk associated with options. Delta hedge can take place by a trader if the trader is not interested in buying or selling an option for directional risk, and only interested in the risks associated with implied volatility, or delta hedging can take place to capture the benefits of long positions in gamma. Gamma, is the change in delta, relative to the change in the underlying market. This means, for a trader that is long a call option, a upward move in the underlying instrument will make the trader longer the underlying instrument. In the example give above using 10 Comex gold options, a move from 1240 to 1260, would change the delta from 50%, to approximately 60%.
This would change the underlying theoretical long position from five contracts of gold, to six contracts of gold (50% of 10 options equals 5 contract, and 60% of 10 options equals 6 contracts). As the market moves higher, a traders can hedge the delta on the option buy shorting gold prices, which will lock in the value of the upward movement. Additionally, if the market moved from 1260 down to 1240, and the trader sold six contracts of gold at 1260 (which hedge the underlying delta of the option), the trader would benefit from a gain of $20 dollars on six contracts.
If the market did not move down but instead stay at 1260 until expiration, the trader would have a gain of $20 on 10 gold contracts (the total number of options that was initially purchased) but would only own 4 contracts (10 from expiration and 6 sold as a delta hedge). If the markets where to continue to rise from 1260 to 1280, and the trader did not delta hedge until after the initial sale, the trader would have a gain of $40 dollar on 10 contracts (options initially purchased), and a loss of 20 dollars (1280 – 1260) on six contracts from the delta hedge. The total benefit would be $280. The key to understanding delta hedging is to realize that the market needs to move more than the implied volatility that is priced into the premium when the market is purchased.
Delta hedging is also important for traders that sell options. Unfortunately, the benefits of receiving premium when selling an option, are offset by always being on the wrong side of the market when delta hedging. In the example of the gold market, if a trader where short a call option, when the market moved from a 50% delta to a 60% delta, the trader would become shorter one contract as the market moved higher. If a trader where to delta hedge buys purchasing six contracts when the market moved from 1240 to 1260, and the market then returned to 1240, the trader would have an unrealized loss of $20 dollars per ounce. The reason that a trader would delta hedge is to avoid the market moving from 1240 to 1280 is the premium received from the sale of the options was only $5 per contract. When selling options, a trader is subject to unlimited losses, which can be mitigated by delta hedging. The same type of scenario would exist for both buyers and seller of put options. The delta and the gamma of the options are extremely important to a trader that is looked to take advantage of movements in the underlying financial instruments and capture as much money as possible from market movements.
The Vega of an option is the exposure an option has to movements in the prices of implied volatility. Implied volatility is a market measurement of how much market participants believe an financial instrument will move during the course of a year on an annualized basis. Usually as fear and uncertainty rise, implied volatility increased, and as calm and certainty are embraced by market participants, implied volatility begins to fall. For an owner of an options (either or put or a call), as implied volatility rises the value of their option rises, and as implied volatility falls, the value of the options falls. The measurement of this type of exposure is called Vega. Since some traders have portfolios of options with numerous strikes, the Vega exposure is very important to monitor. A trader can hedge Vega exposure by selling the options that was purchased or buying the option that was sold, or create a proxy hedge for the option. For example, if a trader purchased an option with an expiration date, that was 360 days from the current time, and the market moved up rapidly, the trader might want to delta hedge and Vega hedge the position. One way to do this is to sell an at the money option, which would create a hedge for both the delta and the Vega. This strategy begins to become complex, since the trader then creates strike map risk, and can turn a trades that was gamma and Vega positive, to one that is gamma and Vega negative.
A fourth type of risk that is inherent within options is the time decay or theta that is attached to options. When an option is purchased, and premium is paid to the seller, each day the value of the option is reduced by the value of time which is decreased daily. For an option that expires in 30 days, every day the option is reduced theoretically by 1/30th until it expires. This risk, called theta, is difficult to hedge unless it is offset by an option that is sold if a bought option is owned. For gamma to be effective, the market needs to move and create a profit theoretically for a trader at a rate that is greater than the theta.
All option Greeks are interconnected. When implied volatility is higher or moving higher, theta is high or moving higher. When the value of an option is rich, gamma, theta and Vega are all rich. By understanding how options work, a trader can dynamically trade then with underlying assets and become very profitable.