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The Fraternity of Options Trading


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

And non-linear is a crucial and central concept when dealing with options. None of the Greeks are defined in straight line, but rather have slopes and curves.

Delta and gamma share a smile. Vega and theta slope down as expiration approaches. And each is tied to not only the price of the underlying security, but to each other.

The delta, gamma, and vega of an option are vastly different depending on the strike price (out of the money versus in the money) and time remaining.

This ever-changing landscape makes predicting what will happen to the price of a single option or a position involving multiple options a difficult undertaking.

Often the option price doesn't always appear to move in conjunction with the price of the underlying asset. It's important to understand what factors contribute to the movement in the price of an option, and what effect they have. In this way, the Greeks can provide a compass and keep you on course.

This doesn't mean you have to improvise, or make adjustments, which is a way of life for option traders. The Greeks can help you quantify the various risks of every trade you consider, no matter how complex.

Know Where You're Going, Not Where You've Been

Let's look at one of the basic adjustments to keep a position delta neutral. The conventional, and believed the most efficient, way to hedge a position is to buy or sell stock against the option owned.

For example, if one buys 10 Apple (AAPL) $140 calls for $2 a contract when the stock is trading $140, the hedge to get delta neutral would be to sell five shares of the stock. And this will work great because if the stock plummets, you'll make money, if the stock rallies, you will also make money. This is because the position is long gamma. But the fact that this will be profitable if there's an extreme move in either direction doesn't make it an efficient hedge. By definition, a hedged position shouldn't make or lose money no matter what the price of the underlying is.

Of course there's no such thing as a perfect hedge and everything comes with a cost. If we flipped the above position around -- sold 10 calls and bought five shares -- it would only be profitable if Apple remained above $139 and below $143.50 a share.

Yes, time decay, or theta, is now working in your favor, but the position is short gamma and, therefore, can have exponentially large losses on a large price.

Option positions have a variety of opportunity and risk exposures, and these risks vary dramatically over time and with market movements. It's important to understand them and the Greeks can be a good guide. Just don't give them the keys to your car or the password to your account.

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No positions in stocks mentioned.

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