There you are in a conversation with a professional trader about their strategy and suddenly the “inside baseball” terms start rolling off their tongue – Delta Hedging, Short Gamma, Theta Burn, and Vega Risk. You smile and nod without perhaps knowing exactly what these terms mean, and just like that, what started as a good meeting now has you distracted. Let’s face it – while these terms are very common in the options trading space – the average investor or allocator may be saying “it’s all Greek to me” (we couldn’t help ourselves).
Turns out these terms are all mathematical calculations having to do with options pricing and risk, with the calculated result represented by different (mostly) Greek letters – Delta, Gamma, Theta, Rho, and (not a Greek letter) Vega. They’re collectively referred to as the “Greeks.” It all goes back to risk. The Greeks are measures of the different option dimensions, or sensitivities, to price, time, and volatility. They’re commonly referred to across the internet when talking options trading – but that talk is typically focused on stock options.
That’s all fine and good, but there’s a whole subset of the managed futures space who trade futures options. These are mostly on the S&P 500 futures, but the point is – there’s a lot of Greek letters flying around these days when analyzing managed futures programs. So, just what does each of these terms mean in relation to futures options and what’s a typical futures option trade that should be paying particular attention to each?
Not the airlines, of course. Delta represents the amount an option price will change given a $1.00 change in the underlying asset price. A Delta of 1.00 meaning the option price will go up $1.00 when the underlying’s price goes up $1.00, a Delta of 0.50 meaning the option price will go up $0.50 when the underlying goes up $1.00, and so on (all else being equal… which it never is). This number can be both positive and negative and always falls between -1 to 0 and 0 to 1. We like to think of it as the amount of directional risk one is taking on in the option, which leads to the related concepts of “delta neutral” and “delta hedging.”
A delta neutral strategy attempts to remove all directional exposure/risk by being in both puts and calls, or by owning the underlying asset against the option strategy. In that manner, a trader can target just an options time or volatility decay and not worry about which way the market is moving, again, all else being equal. Trick is – the delta’s aren’t constant, they change depending how close or far away the underlying asset’s price is to the option strike price. As it gets closer to the strike, the option will trade more like the underlying, which can cause delta neutral strategies to employ “delta hedging,” where they purchase futures to take on directional exposure in the opposite direction of the “delta” on their option trade, thereby reducing the delta of the overall position.
Quick on the heels of Delta is Gamma. We talked above about Delta being dynamic and changing as the underlying asset’s price gets closer to the options strike price – and Gamma is the Greek which measures Delta’s sensitivity to that price movement. Gamma is how fast the Delta changes after a 1 point movement in the underlying, and the key to understanding it is that the Delta doesn’t change the same amount for every option based on a given futures market. Delta may accelerate faster for options closer to the money, shorter duration, and so on. Gamma is the measure of that acceleration factor.
When we hear of a trader being “short gamma,” that’s saying they’re betting against a sharp move happening sometime soon. They are betting the underlying doesn’t quickly approach their strike prices, forcing their deltas higher and eating into their short option position. Being short gamma means the closer prices get to your underlying price, the worse things get.
Options are unique from buying outright stocks or futures, because there’s a time component to them. You’re investing in something moving such and such amount by such and such time, versus just moving a certain amount when doing outright investments in the underlying. And what’s more, it’s a binary event for the options value at the expiration date on whether the option has value or not, leading to the concept of time decay in options – where every day closer to the expiration date the option should lose some value because it has less time to move the distance required for the option to finish in the money. The amount of decline each day in the option’s price due to this time factor is Theta.
Vega is the only one of the Greek terms that isn’t part of the Greek Alphabet. Maybe they called is Vega because it starts with a V, and volatility starts with a V? With that weak setup, you can guess that Vega has to do with the option price’s sensitivity to the volatility of the underlying asset. Vega measures how much the option’s price will move given a 1% move in volatility, and is quoted as such, with a Vega of $0.25 meaning the option should rise $0.25 for every 1% rise in volatility of the option’s underlying asset. And just like Gamma is a sort of qualifier for Delta; Vega can be thought of as related to Theta. That is, the more time left til expiration, the greater the Vega of the option. Imagine the cone of uncertainty they show when tracking hurricanes. That cone is the Vega of the option, and is greater the further rout in time you go, as volatility today can push further out ranges even wider.
Rho is the least used of all the option Greeks in our experience, measuring the sensitivity of the option pricing to interest rates. Interest rates? What ?(%^ Well, consider that buying an option means tying that money up until the expiration date, and selling it likewise means the ability to earn the income on the proceeds until the expiration date. Given these factors, option pricing models consider the cost of money, or interest rates. Rho works like the rest, essentially being quoted as the amount an option will move given a 1% change in interest rates (it was obviously conceived of before interest rates sat at zero for half a decade).
These definitions can get tricky. It’s important to not get lost in the weeds, and hopefully with a brief understanding of them all, it won’t trip you up during your next meeting with pro traders.