Using Option Greeks in option trading

Trading stocks is easy, you already know how much you are going to make when you are right and how much you are going to lose when you are wrong.  What is trick are options.

There are so many variables that go into pricing an option. So, how can you estimate how far an option will move if we are right?  With the option Greeks, the delta, gamma, and theta.

So say we find a stock that is trading at $45 and we expect it to go to $50. We might want to buy the $45 option trading at $3, but we need some way to measure how much we can expect to make if we are right.

The first thing we can look at is the delta which will tell us how much an option will move for every 1 point move in the price of the stock.  But the delta alone does not give us a good estimate.  As the stock moves the Delta changes as well, so gamma tells us how much we can expect the delta to change for every 1 point move in the stock.

Let’s say the delta for this option is $.50 and the gamma is $.10.  Since we expect the stock to move $5 we would expect this option to increase $.50+$.60+$.70+$.80+$.90 or $3.5.  We would expect the option to be worth around $6.5 once everything is done.

But that doesn’t tell us the whole story. Options melt away as they get closer to expiration.  To calculate how much they will melt away we can use theta.  If theta is $.05 we would expect the option to lose $.05 for every 1 day we own it. 

If we believe it will take around 10 days to make the move we can determine that the option will lose $.50 during that period, which means that we would expect the option to be worth $6 if it made the move that we were expecting it to.

Of course it is not an exact science, but it can help us get an idea of how we think the options price will change.

For more on the Delta visit http://www.stocks-simplified.com/option_delta.html