Calculating Options Greeks That Matter: Delta, Gamma, Theta - Raj Malhotra

all right everyone I'm Raj Malhotra that's me I like air my resume around me at all times so don't worry about it so anyway we're gonna be talking about option Greeks today the ones that matter Delta Gamma theta and I promise you this will be interesting and exciting so let's talk about it a few misconceptions about options trading you all here they're very sophisticated they're very risky they're hard to understand and they need to be taught with payoff diagrams like we're a boring economics class those are all lies those are what option guys tell girls at bars to make themselves sound smarter and what we tell our bosses so we get paid more so it's not all it's not a total loss so I'm gonna teach you at options in a way more interesting way and it hopefully you guys will enjoy it so what are some it's about option creaks there are also some misconceptions so let's talk about those they'll tell you Greeks are the most important thing to understand when deciding which options to buy that's something that finance professors will tell you because they don't know how to make money trading options they'll tell you if you can calculate the Greeks properly you will make money trading options I know plenty of guys that can calculate Greeks and have no idea how to make money trading them they'll tell you Greeks calculating Greeks is more the more it's more important than coming up with good fundamental ideas listen you can come up you can know bet options backwards and forwards if you pick if you pick if you buy calls and stocks that go down you will never make money if you know Greeks still be ok I figure out that one strike that one maturity that will always make you money question I always get their asses which is the right option to buy well nobody knows until after the fact but having said that there are reasons why you should know learn about the Greeks what key Greeks help you do besides totally up your banking system so if you do if you get a firm glass grasp of the Greeks they will help you judge which options which is the best one to trade based on your outlook on the on your line once you have an idea of where you think a stock is gonna go if you understand fully how the Greeks work they will actually help you help you maximize your P&L in a trade they can help you predict what will happen the price of an option is up as the market changes it's not always that simple how how a option price changes prior to maturity without understand how the Greeks actually work because if a stock moves X percent in say say an option expires two months from now it's it's not easy to predict if the market moves 10% how much the option is actually gonna move if it if this stock move rallies 10% in ten days it's not always it's not that easy to predict unless you actually understand how the Greeks work and if you don't understand the Greeks you'll have no idea what your potential P&L will be in in a trade idea and obviously that's the most important thing that for you to predict like don't you want to know you want to have an idea how much money you're gonna make when you when you do an option trade and honestly that's one of the biggest mistakes most retail traders have they'll buy don't just decide to buy an option because they think because they like it they have a trade idea they think okay apples gonna go down I'm gonna buy puts but without any understanding of how much money they're gonna make or why that's gonna happen in their specified time period and they'll have no idea what pl what their pl will be and if you know the Greeks an option trader can make a more informed decision about which ones to trade and when to trade them you never come up with a trade idea and say I always I always want to trade options in fact you'd be surprised more of my students I talked them out of trading options than into trading options because you have to have a reason why the stock is going to move in a certain time period if you don't believe there's a couple students here I've talked out of many option trades so let's let's go through a few option basics some of you guys have never traded options before so I'll explain it to you very very simply and easily call option the order of a call option gives the investor the right but not the obligation to buy a stock at a specified price which is a strike price at a certain time period what does that mean if you buy a call option you want the stock to go up as much as possible before expiration date that's all the owner of a put option gives the investor the right but not the obligation to sell a stock at specified price which is a strike price at a certain time period which is the expiration date again very simple if you buy a put you want the stock to go down as much as possible before expiration date let's go through some other more option basics just so we can before we get to the good stuff so the premium that's what an option costs if you see a price listed on your screen you have to multiply that price times 100 since each option contract represents 100 shares so for example if you see a call option is offered at $2 you have to pay $200 for that option and that represents a hundred shares of that stock should you go through the strike price the strike price it's the price that you agree to buy or sell a stock at a later date so for example if if the stock is trading 102 dollars if you buy the 105 strike call you're able to buy that that stock at $105 at a later date hoping that the stock is above 105 dollars so obviously in that scenario you'd want to buy a stock that's for 105 you want to buy a stock for $105 if it's traded 110 dollars in the open market in theory then you could just sell it right out and then collect your premium collect your P&L the expiration date the last day to exercise an option the intrinsic value that's basically what a stock is in the money at the moment like in that last example the stock is very 110 dollars and the strike is 105 you have five dollars of intrinsic value the time value that's what's that's the premium over the intrinsic value which is also referred to as the optionality left in an option we'll go we'll discuss a little bit more that later on and the implied volatility volatility is actually the only input in an option pricing model that there was any debate everything else to strike the time to maturity spot price everything else is undebatable but the implied volatility is the only thing where there is some debate and that's actually what option market makers are betting on what they're actually pricing so unlike most retail traders that are trading for Direction option market makers are trading for volatility so they're basically betting on that implied volatility so if you're if you're trading an option versus a market maker you guys both actually have different objectives and you can actually both profit off you both of you can be profitable it's not an options it's actually not a zero-sum game an option market maker that's actually smart can actually make money while you're also making money which is how a lot of Wall Street firms actually make money that's how we would make money we were if we were trading with smart hedge funds like my friend over here we would all what we would provide liquidity for them in options but no but with us knowing what they're doing we could both profit off that so that's a partnership that hedge funds and market makers or Wall Street firms have that we can worse mutually beneficial so we can discuss that offline a little bit more if you want the option Greeks let's define them and then let's discuss how why they're important so the Delta the Delta is how much the value of an option should change when the price rises by one dollar so simply if the stock goes from a hundred dollars to one hundred and one dollars if the 50 Delta that means the option price should go up by fifty cents and if it goes down from a hundred to ninety nine dollars it should go down by fifty cents the gamma is the rate of change in an options Delta per one point moving the underline so like if a stock goes from hundred to 101 it probably has a different Delta at that point so how much that Delta changes is actually the gamma so Delta is how much it moves gamma is how much it changes theta is the time to cave an option it's a dollar amount an option losses per day since an option has an expiration date it's worth a little bit less every day and that's and that is the theta of an option in Vega is the how much an option price changes per one move of volatility so for example so if implied balls go up all option prices go up and apply balls go down all all option prices go down so let's talk about options pricing I'll just put all these up at the same time this is not super important right now but I mean I just want to go through a little bit each one the most important ones are when pricing options when affecting option prices are the intrinsic value the time value and the implied volatility value I touched on those a little bit already there are other factors that influence option prices but they're not super important but the dividend rate prevailing market conditions is it's you know as a whole market becomes more volatile all option prices across all stocks tend to go higher and lower as you know the VIX is historically at a near a very historical low what's at 11 something if the VIX goes up to 20 you'll see option prices across every equity go higher supply and demand for options matters special in names that are more than or less liquid you know as the market makers are setting positions if they get if they get keep getting taken on one side of the market they're gonna they're gonna move their markets around to reflect the to way volatility and interest rates also matter a little bit this is the nature of options chain after the presentation you'll understand what all these things mean this is strictly from TradeStation so let's go through Delta first Delta is like I said how much the value of an option moves when the underlying moves by $1 all call options have it between a 0 and a 1 Delta that's simply because if you're a long-haul as the stock price goes up the call option always is worth more so it's always a positive Delta put options haven't a contrary I have a negative Delta so as stock prices go higher puts become worth puts are worth less so therefore they have a negative Delta ant on touch on this a little bit before but at the money called Delta has around a 50 Delta which is basically because when something's got the money it's a 50/50 coin flip whether the stock goes up or down so therefore it's around a 50 Delta now the money called option typically have somewhere people zero in at 50 Delta I mean the money usually has to be doing 50 in a 1 Delta never understand why that is if something is far out of the money it doesn't change as much but as something's weighing the money it changes per per dollar actually I'll explain this a little bit more the next slide and now the money put Delta has between 0 and 0.5 Delta and then the money has between a 50 and a 1 Delta and as the underlying price moves the Delta option changes by the gamma now let's discuss what Delta actually does for you this is the most important thing about Delta even if you don't trade options this is one thing you should learn if you look at the options market this can be very very valuable tool for you to look at Delta's of options well it's not entirely accurate the Delta of an option is approximately the probability that an option finishes in the money but for example a deep in the money option that's virtually certain of finishing the money say 99% chance will have something like a 99 Delta if you look at an option chain you'll look all the very deep in the money options have 99 Delta's or 100 Delta's meeting that just they just go up and down one dollar move means a one dollar move to the option one day I'll move the underline means a one down move to the option because it's it's gonna be in the money it's a hundred percent it's almost a hundred parents certainty that this is gonna be in the it's gonna fish in the money so it's actually more valuable for out of the money options though like a far out of the money option you'll see have a with no chance of expiring the money will have a zero Delta and like Anton talked about earlier and at the money option has a 50/50 probability of being in the money because so because there's a 50-50 chance of the stockholm up or down in one day and as you if you look up the chain if you look at higher strikes you'll see if you see like a 38 Delta that's approximately a thirty eight percent chance that that option will that's that the stock will trade above that price by expiration so therefore Delta can be a very valuable tool to estimate probabilities so there's clear there's a clear linear relationship between Delta and probability and it's really this is really this is especially good if you're looking around earnings and other catalysts driven events it can be a good way to actually estimate what are the chances of you making money of this stock getting to this price by this time when you get really good at deltas you can start you talking with two other option traders using in everyday life like like what like what what like if you say hey what are the chance you'd be showing up tonight that's about a 50 Delta or what the chances of that girl go home with you zero or the chance of your friend Bob getting an STD in Vegas 200 again the most important thing is make sure you understand that linear relationship because it is varied it could be a very valuable tool let's talk about gamma gamma we talked about its change its to change any options Delta per one point move the underlying assets price so basically any time you're long an option your long gamma anytime you're short an option your short gamma gamma can also be useful to describe describe life events like let me ask you a question if you were working an investment bank and you were the lowest man on the totem pole if you were like there was 12 guys in the desk and you're number 12 do you think you're a long gamma or short gamma who thinks long gamma who thinks short gamma you're supposed to speak who thinks long gamma yes or no no who thinks short gamma you're all wrong if you're a long gamma if you're the bottom of the pole you want change if you want you if you're if you're the bottom guy there you want 10 guys ahead of you get fired because then you move up to number two if you're Lloyd Blankfein do you think you're a long gamma or short gamma correct right you're short you make 23 million dollars here why would you want anything to change you want no change when you're at the top and at the bottom you want as much change as possible so think of that in life you guys I could tell her probably long gamma that's why you're here maybe some one day you'll be here so that'll be then you'll be short gamma so when when an option is near at the money that's when gamma is at its largest that may that's clear right that's the most gamma there's there's you're right the money that's what the most can change when adoption is deep out of the money or deep in the money the gamma is small because the option prices don't change that much like if this stuff like if you're the stocks trading $100 and is 120 strike call that Stockman was up adopt two dollars it's option price not gonna change it very much because it's still it's still pretty worthless gamma calculations are most accurate for small changes of an underlying price yet gamma is constantly moving so it could be a good way to predict a small at one point move but a ten point move it's hard to predict because the gamma it will change over that the life of that move so when a stock has a big move it can be hard to estimate the pl because the fact that the gamma is inconsistent and that's why it's the hardest one to predict with a big market move and that's why sometimes calculating gamma it actually requires complicated software it's not it's it's the hardest one this if you if you software for anything calculate gamma is probably the hardest one to estimate however understand this this is very important gamma is the creek that adds the most of your P&L if you're buying an option you want to buy an option with a lot of gamma and you want it to move a lot because when it expires it has this acceleration factor so when you buy an OPS you want it you want to buy one with a lotta gamma and then when he wakes pot when it expires you want it to be deep in the money and have a little gamma u basically gamma is like basically like try a baby get getting the most bang for your buck everyone good with gamma all right now let's talk about theta the say you know theta is just simply the time decay it's what it's what an option losses per day and there is no way to mitigate the risk there's no way if you buy an option just understand you're gonna you're gonna you're paying data every single day and there's nothing you can do about it it's greatest when it's closest to expiration at the money just like gamma and most options actually expire worthless due to theta because many retail traders will look at an option chain and decide oh this one looks really cheap they'll buy a far out of the money option but the option will generally expire worthless before they before it actually gets to the price they need to get to and therefore it's the Greek that's actually the most that the most misunderstood even though to me it's actually the most obvious it's actually the easiest to explain butts the most I'm just misunderstood which is kind of surprising here's a graph of what theta actually looks like if you can see like you know from 120 days out to 90 days it's it does it there's not that much theta there's not that much theta and as soon as you get too close to expiration it almost falls off a cliff so it's almost it's so inversely related to time the less time to maturity the more there's more theta it's not like it's not like a linear relationship so the problem with a lot of bad retail traders they never look at their theta arrests they they look at everything else except what it cost them every day remember this this is very very important remember not only if if you when you buy an app not only do you have to be right you have to be right in a specified time period so you're actually when people tell you that you're buying options reduces your risk that's not true that's not entirely true that's what people that don't understand how options trade tell you they tell you okay this is now you have limited risk well that's true in one sense it's it you are adding timing risks to the your trade so for example like if you have if you if you have you have a bright idea one day you think this stock is gonna go up it can you could it cannot go up for six months and if you buy stock you won't lose any money but if you buy options you're adding that time and risk too and you won't lose money so you're adding that timing risk which is you can have a black ace that you can have a great idea but it you can be wrong for example like Christian Bale's characters remember he based has the greatest trade idea in the world and what in the history of trading one of the greatest ones he basically buys puts on the housing market and if you remember in the movie it's he's basically three months away from being bankrupt what is when his investors tried to redeem if he did if he allowed them redeemed she lost 100 percent of his money and said he end up making like what seven hundred percent or something like that so that shows you how timing risk how important timing risk is engine options trading the best trade in the world could have been the worst trade in the world given three months time sake if theta is like if you're dating a supermodel I mean I could look around this room and tell them that none of you ever date one so but think of it like dating a supermodel right each day your wallets a little bit lighter each passing day becomes a little less attractive and way more annoying and eventually falls off a cliff so now that you know what all these are what all the Greeks are you could see if you look at this is TradeStation you can see what all these columns mean you can see what the implied ball is you can see what the fááá is the gamma the Delta the deltas go higher as the strikes go higher which kind of makes sense the gamma is that that's because they're too small the Thetas are greatest at the at the at the money strikes now once you see all these numbers you actually know what they mean now so glad for you alright so let's see if you have learned anything this is a little test this is gonna require some interaction so you guys ready get your thinking caps on alright so how does the follow Totti actually affect the other crease how does like each one obviously they have they affect each other right they're not they're not uh they're not on they're not on an island they they each each Greek affects the other one so let's see if you can pass these tests right here so when implied volatility goes up in an option what happens to the Delta so let's examine each one so and if implied volatility goes up what happened to and out-of-the-money Delta does it go up or down who thinks up who things down you're supposed to speak all right well I'll let you up took the first one and and out of the money option if the applied ball goes up the Delta goes up so we're saying why right exactly yes the bright simple the proto likelihood of a big move is greater so the probability of it being in the money is greater well done you did learn you might date a supermodel okay what happens to a uh if a plied ball goes up what happens we had a band and at the money Delta so if you think it goes up say up if you think it goes down stay down it's correct stays the same well done no change right cuz it's not the money it still doesn't just because of all Tony goes up the chance of going up or down is still the same it's still 50/50 you write to write the magnitude if we going up or down might be different but the coin flip is still up or down it's still 50/50 no change in Delta this one you should get now implied volatility goes down what happens to out of the money Delta who thinks it goes up say up who thinks down oh my god you guys are actually learning something it goes down or sometimes it doesn't move it doesn't move for very far out of the money options but generally it does go down obviously if it's zero it you can't go below zero very really really far out of the money like one Delta options don't go down to zero so you guys are getting there all right I haven't at the money dealt and at the money option Delta implies law Goes Down you should know this what do you think no change see see how much do you guys learned gradual ations all right did you get you're doing good so far but now it gets harder let's talk about gamma what happens with volatility volatility changes affecting gamma so what happens to an out of the money option gamma when it bought implied ball goes up what happens to it out of the money option gamma does it go up or down who thinks up who things down wrong the out of the money option gamma goes higher why is that it's the same reason Delta goes up for now and out of the money option right again the gamma goes up because the Delta goes up as well how about this one and at the money option gamma implied Bob goes up who thinks gamma goes up say up who thinks down stay down one person said down down is right no change why what why is that you said you said down what do you think down what's that no not really it's because don't get if you would don't worry you got it right but no one else did so don't worry whoever got it wrong please don't worry cuz you're not supposed to get this right the reason is the gamma is greatest when it's at the money right so when there's a greater chance for a bigger move of the implied lagos up so that all the at the Delta the out of the money option Delta's the reason this makes gamma is greatest was that the money right so when a pod Bob goes up all the deltas of the out of the money options are also higher so the Delta has actually changed less like the option price to change less but basically like remember we talked about how you wanted like the greatest change in the acceleration factor with with with lower vol there's more gamma because it moves matter much more so basically as like as when vols almost zero and he have a big move it's worth much more so that's why the when the fly ball goes up the at the money option goes down and likewise the other way everybody confused yet it's a cuz when when Vall goes up that the moves matter that the moves have actually matter less so that's why when likewise when implied balls go down the gamma goes higher for an at the money option because again it's back to that acceleration factor it when when Vagos up the delta out of the money options goes up so therefore the gamma goes down alright so here's a question that most people in the room will get wrong including most of the mentors as volatility approaches infinity what happens to the game of options gamma goes up who says up what's that that that that that might be true the model does break but what happens to the game of options it approaches zero actually you're right so therefore you're right the model does break because it actually approaches zero because basically what happens is when polity it becomes infinite the option prices just don't change just because they can literally trade anywhere remember when I said before how like you option traders like to impress people with its Alice smart they are this is exact what I'm doing right now so here's the question that nobody in this room will get right including all the mentors and Anton so what happens as volatile as volatility approached in fini what happens the Delp of options what's that it goes up to infinity no that's not correct that's good guess though at least she guessed no they all have a 50 Delta was that right no one got it right does everyone know why exactly you're right it could go anywhere so what what right they don't really yeah they don't really change it what happens is the markets all volatile the everything base has a 50/50 chance of finishing in the money so remember that Delta probability rule they basically just the model does break but basically all options have a 50 Delta at that point because they just don't change like that the price has changed but it's kind of it's kind of a weird question but basically when when when there's infinite volatility the other line can trade at any price so literally anything can happen so they all had 50 deltas which is a very complicated question so basically like when when volatility becomes infinite it's like if you drop a heroin addict in Bangkok with six months to live anything could happen not not speaking from experience what happens to theta what happens to out of the money options when fit when implied Bob goes up just a to go up or down whoo things down who thinks up it's up why is it up because the options are worth more but the timing maturity is the same so therefore theta just has to go up because at the time the amount of days are still the same but the option price is worth more so it's it did take the cut the premium divided by the time and it just so it's always more how about it would apply if all goes up what happens at the money option theta does it go up or down who things down who thinks up no it goes up again the same thing that is a very linear relationship the yeah if the options worth more and the same amount of that days to maturity it has to has to have more theta it's like monopoly goes from $1 to $2 and they're both in they if there's 3 days to maturity the theta is just more because it's the options worth more and has to decay more it's like a it's like there's a $10,000 car or $100,000 car which one is which one decays more which one which one loses more value when it's driven off a lot in dollars every automobile when it lose like 20% of its value when it's driven off a lot a brand new car so obviously in real dollars a $10,000 car loses two thousand and a hundred thousand dollars called car lose a twenty thousand so it's just simply a linear relationship when Bob goes up all options at more theta and it's also greatest when you get close to maturity now that we've discussed all the Greeks when is it useful to know the Greeks besides when you're trying to get free gyros so Greeks are a very very important for market makers in fact that's the most important thing for market makers because they have a different strategy than directional traders guys like me sitting at a desk managing a portfolio of options need to know Greeks backwards and forwards if you want to understand how market makers trade I did a mine one in New York was about how how to think in price options like a market maker but some takeaways are when a market maker trades an option he immediately needs to trade stock to cover his Delta risk so when you wouldn't like what we talked about before when he if you if he sells a call he and he immediately needs to buy stock to hedge his Delta because he's betting on volatility not direction he's not taking the other side of your bet and hoping that stock goes down he's betting on realized volatility market makers that usually have a portfolio of options in different stocks or indices and they have a basket of different names so he's constantly looking at his overall Delta Gamma Vega theta portfolio risk just like you're managing a portfolio of stocks he's managing a portfolio of Greeks so therefore they're always shocking in their portfolio this is thing that they always do with with their portfolio and literally every day if not more than once a day so basically when you shock your portfolio the market maker will look at what happens if the stock moves down 20 30 % or more and then make guesses of what's gonna happen to vall and what's gonna happen to their gamma and their Vega and therefore come up with their worse their best in worst case scenario for piano and that's obviously very important to all market makers and also like what what their book is gonna look like when it does move that how is their how what's their new Delta what's a new gamma exposure what's a new Vegas pose you're gonna look like so like I said understand the Greeks is the most important thing for a market maker but why is it useful for you guys to understand Greeks because you're not going to do that to your portfolio you're not gonna have a basket of 10 of 17 options in eight different names well it can be very useful to you because you can it can help you punish them see understand that Greeks can help you make a more informed decision of whether or not you might be better than trading stock often there you'll see strikes with a lot of open interest and if you know there's a lot of open interest and know how market makers are positioned there's a lot of stock that they may need to buy herself move through strikes and you can use that to your advantage as a retail trader knowing like what a lot of times you'll hear the term price action it's like what's the price action doing is it is it sometimes it's not real money buying sometimes it's option market makers just trying to rehash or portfolios knowing like because the stock goes through a strike they need to buy and below a strike they need to sell if they're negative if they're short gamma so it's a very important thing to understand of the way they market makers need to reposition themselves and you can use that to your advantage should should you have a good fundamental view and you can profit off that sometimes it can help you determine whether it's more selling your stock just sometimes it has like a rally through a strike and weight and whether that's a real move or maybe you want to sell half your position or hedge it or take profits but just knowing what the market makers are doing there it can add to your bottom line P know so you still need to drive your ideas with fundamentals and you can use options to express your ideas but you only after assessing the marginal benefits of options trading which is the topic I covered in last year's London seminar and furthermore when you're cognizant of the Greeks you can make informed decisions at big open in two strikes and deciding what to do with your positions and obviously understanding the Greeks can make you understand price action and equal more profits so this the kind of stuff I cover in mentoring here are some other things we cover how to behave around earnings and other catalyst driven events when is the optimal time to buy around these events how do you estimate the new Delta and gamma when when the stock has a big move using average gamma other tricks to estimate P and L and an options trade I said before out gamma was very hard to predict but there are ways to guess with a with a with pretty good certainty you have what your Pino and is gonna be due to gamma and other other tricks if you look up up up and down the option chain and one things really come around lately is how to how to play these options around turnaround stories especially with volatile balls at these levels there are some ways that have been really they've been working very well so let's summarize what we learned today options are not sophisticated risky and hard to understand you guys pass most my questions so there you go the benefits of options can be huge when understood and traded correctly knowing that Greeks is not them it's not more important than coming up with good fundamental ideas however calculating Greeks and calculate Greeks won't make you money on a standalone basis however they can be very very useful understanding them can help you predict what will happen to the price of an option as the market changes and if you understand the Greeks a retail trader can make more informed decisions about which options to trade and when to trade them and how to profit off them help you guys profit off them going forward thank you guys [Applause]

Channel: InstituteofTrading

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Keywords: Institute of Trading and Portfolio Management, What's On Your Mind, Hedge Funds, Investments Banks, Trading, Stock Market, FOREX, SP500, NYSE, Millionaire, Billionaire, Money, Investing, Finance, Raj Malhotra, Options, Derivatives

Id: Qs0jNUtHnVc

Length: 39min 24sec (2364 seconds)

Published: Fri Nov 01 2019