Futures For YouQ&A
Futures For YouInside The Futures World
Want to find out how the futures markets really work? Carley Garner is the senior strategist for DeCarley Trading, a division of Zaner Group, where she also works as a broker. She authors widely distributed e-newsletters; for your free subscription, visit www.DeCarleyTrading.com. Her books, Currency Trading in the Forex and Futures Markets, A Trader’s First Book on Commodities, and Commodity Options, were published by FT Press. To submit a question, post your question at https://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C.
MARKET SPECULATION
What are the option greeks and can they be applied to commodity options?
Collectively, the option greeks are a group of equations used to measure and identify the sensitivity of an option price to outside forces such as price changes in the underlying asset, the passage of time, or changes in market volatility. The greeks can be useful to option traders in many ways, but are most often used as a proxy for trade probability.
The greeks are similar to other market tools in that they tell traders what has already happened, not what will happen in the future. This is the case despite some option probability software that attempts to project trade probabilities. For instance, the greek calculations take into account today’s market environment but could adjust dramatically if volatility or market sentiment changes significantly tomorrow. In other words, the greeks and any resulting probability calculations are dynamic, not static. Accordingly, traders should refrain from allowing favorable greeks to lure them into complacency.
In the case of commodity options, I argue that the greeks might be less reliable than is the case for options on stocks. This is partly due to generally less liquid market conditions (although many commodity markets are highly liquid) and leveraged underlying assets.
Here is a list of what I believe to be the most useful greeks along with a short description of the role they play in market speculation. I’ve listed them in the order of what I believe to be their relevancy.
Delta — In my opinion, this is the most telling and helpful of all of the greeks. It is also the simplest — and perhaps that isn’t a coincidence. Traders often try to overcomplicate market analysis and this can work to their detriment.
Don’t assume that making money is as simple as selling an option with a low delta and a high theta and watching the value melt away.The delta measures the rate of change in an option value relative to a respective change in the underlying asset. The equation is straightforward (change in option price/change in futures price). The delta will be a value between 1 and zero for calls, or -1 and zero for puts. For example, if the delta of a crude oil $100 call is 0.25, often referred to as 25%; for every $1.00 crude oil rallied, the option would gain $0.25 in value. Or at least that is the expectation of the theory behind the greeks. However, deltas change with market price and conditions, so don’t expect the math to always work out as well in practice as it does on paper.
Many traders use delta to measure the risk of the option expiring in the money. In the example above, a trader would assume that an option with a delta of 25 would have an approximate probability of 25% of expiring in the money. Conversely, the odds of the option expiring worthless would be 75%. Once again, the greeks are dynamic; a 25% reading today can quickly turn into a 50% reading within a few trading sessions. You can’t assume the current inference of any greek will be stable in the long run.
Vega — This greek measures the sensitivity of the option value to volatility in the underlying asset. Vega is typically expressed in the amount of money the option value will gain or lose as volatility rises or falls by 1%.
Theta — This greek measures the sensitivity of option value to the passage of time. For example, if the $100 crude call had a theta of 0.04, a trader might operate under the assumption that the value of the option would lose approximately four cents per day if all other parameters remained unchanged.
As a reminder, the greeks are a snapshot of today’s environment and not a means of predicting what tomorrow will look like. Don’t assume that making money is as simple as selling an option with a low delta and a high theta and watching the value melt away. On the other hand, an option buyer must understand the obstacle of theta (time value erosion) and factor that into his or her risk and reward profile. Unfortunately, most option buyers experience the wrath of theta as opposed to profiting from a favorable vega.