Some of the best technical tools out there are what we call the “Greeks.” Delta and gamma are particularly helpful at improving your probability of finding a winning trade while lowering your risk. Hence today’s topic: options Greeks explained.
In short, these two Greeks will help you understand the probabilities of price movements in a certain timeframe.
Options Greeks explained
Delta is the amount an option will move with a $1 move in the underlying asset (in most cases, a stock). The delta moves constantly with time and the price of the underlying.
Gamma is derived from delta. It’s the rate of change the delta will move; it is either positive or zero. The key here is to identify a strong rate of change up or down in gamma, depending on your position.
It is extremely helpful to know how fast or slow the delta is likely to move, because a slower (or lower) gamma is a huge advantage to the premium seller.
If you are short options (delta), you want to see that rate of change slow down so the gamma heads toward zero. This is an ideal scenario when volatility is low and not moving up or down.
For instance, let’s say you’re short put spreads. You know that falling gamma means option prices are falling. Because you paid a credit, you want to see the options expire worthless to keep the entire credit.
If you are long options (delta), you want to see that gamma expand, giving your options a greater chance to overcome time decay. This is an ideal environment when volatility is rising.
How delta and gamma helped us find a winning trade
A few years ago, we sold RUT (Russell 2K Index) bull put spreads with strikes at an area that were deemed “safe.”
(Spreads deliver less return but define our risk to the size of the spread only. If the underlying plummets in value, we won’t be wiped out. We are favored to win for the amount of time remaining.)
We were looking at a 1320/1300 bull put spread (sell 1320, buy 1300) for the next monthly expiration – just over two weeks out. At one point during the day, RUT was down to about 1355, penetrating the lower bollinger band. This is a low risk entry point and therefore a good place to open this type of trade. You collect 2.30 for the spread and then just wait it out for 12 trading days.
At expiration, the RUT was at 1400, nowhere close to the short strike of 1320. As a result, we kept the entire credit of 2.30 when the contracts expired worthless. Selling ten spreads would have resulted in a cool profit of $2,300 for the 12-day period, a very nice annualized return.
The very low delta (about 12% at the time) and low gamma were enough to convince us that this trade had an excellent chance of working. Simply put, the trade has an 88% chance of success. We picked strikes that would be far enough away from trouble but with the understanding the heat could be turned up at any time.
Repeated over and over again this strategy can be an enormous boost to your portfolio. With options Greeks explained, you can start using delta and gamma to win with high probability, low risk trades.
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