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The Fraternity of Options Trading

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You can trust delta as much as you trust your pledge brother -- after a few drinks.

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This forces you to look at that fuel tank, or your capital and margin requirements, and the costs associated with carrying the position under these new conditions. It's time to slow down your speed, or reduce your delta, because it's clear now that you're headed in the wrong direction. It's time to pull over, reassess the situation, and make an adjustment.

Those Greeks, who had mapped out a clear risk/reward profile and had promised a smooth ride, are now shrugging their collective shoulders and saying "You screwed up, you trusted us."

But how did they fail? After this long and laborious analogy, let's drill down and try to learn exactly what the Greeks are, what they aren't, what their limitations are, and what they have offer.

A Derivative of a Derivative


The components that go into pricing an option are based on factual numbers, while Greeks are strictly theoretical. As such, the Greeks are a derivative and provide a rearview mirror view.

Basic pricing models such as Black-Scholes use five inputs: current stock price, time remaining until expiration, strike price, prevailing interest rates, and implied volatility are known or factual numbers.

Actually, the implied volatility part of the option pricing model is the "X" in the calculation. In essence, IV is the "answer" to the pricing equation. The price of the option is the price, and IV is the result. You can argue they may be wrong until you are blue or broke.

In a sense, the same holds true for the Greeks. They're derived from the option's current price and their values are projected based on mathematical models, and as such, they are second derivatives.

In fact gamma, one of the powerful forces, is a derivative of a derivative, in that it's a measure of how a change in delta will impact the value of the option.

If all of this sounds a bit intimidating, you can take comfort that using a platform such as TOS does most of the heavy lifting for you in that its proprietary software performs the necessary calculations to provide an accurate value for each of the Greeks.

So while Greeks may have their limitations in terms of prediction, they're not without value for defining risk, and more importantly, helping to make adjustments in dynamic and changing market conditions.

A Compass, Not a Map

To beat our car and road trip analogy into the ground, one can consider the Greeks as a compass, rather than a map. Greeks can't be viewed in isolation of what may be changing terrain. They might point true north, but if there are hills and streams to forge, the path won't be linear.
No positions in stocks mentioned.

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