Greeks Predict Prices at Options Expiration

Third week is climax of the battle between theta and gamma

   

Option expiration week ushers in some fascinating dynamics when it comes to option pricing. And when we get into pricing that means you have to address theta and gamma, two of the Greeks that every options trading investor should know. Understanding these Greeks as you head into expiration week can mean the difference between a winning trade and a big hit to your wallet.

And is it a coincidence that in ancient Athens the Theta symbol was used as an abbreviation for death? After all expiration is a kind of death with a lot of strikes leaving this world. For that matter, a lot of options trading investors who hold bad trades die a little every day until expiration.

Let’s look at how these two Greeks impact expiration and option pricing. For my examples, let’s consider we are discussing the behavior of at-the-money strikes.

THETA

theta Greeks Predict Prices at Options Expiration

Theta

Theta measures the rate of time decay of an option per day. It can be either positive or negative. Option buyers acquire negative theta because their position loses value as time passes. Option sellers acquire positive theta because their position makes money as time passes. The rate of time decay is not linear, but rather exponential. That means it speeds up as expiration approaches.

That’s why traders are drawn to selling short term options which lose value at a quicker rate than long term options. Put simply — Why sell an option losing $5 a day when you can sell one losing $25 a day? This explains the built-in incentive for traders to utilize short-term options when seeking positive theta.

Be careful though. There are other forces at work that should temper your enthusiasm for aggressively selling short-term options. Many traders learn the hard way that having a one-variable mind in a multi-variable world is a recipe for disaster.

GAMMA

Gamma has always been a property of options I’ve found easier understood through experience rather than reading an article. By definition it is the rate of change of delta per $1 move in the underlying stock. Gamma can also be positive or negative. Option buyers acquire positive gamma while option sellers acquire negative gamma.

gamma Greeks Predict Prices at Options Expiration

Gamma

Gamma rises as expiration approaches which causes some interesting problems to option sellers going into expiration week. An adverse move in the stock can cause losses to rapidly mount.

A position with positive gamma is one that will see its gains accelerate and losses decelerate. Think of a long call or a long straddle. A negative gamma position is one that will see its gains decelerate and losses accelerate. Think of a covered call or an iron condor.

Positive Gamma = Long Call/Long Straddle

Negative Gamma = Covered Call/Iron Condor

The absolute worst example of negative gamma risk killing a trade that I’ve seen is when a buddy of mine was short September call spreads on the Russell 2000 Index (.RUT) in 2008. With two days until expiration the RUT was sitting at 676, placing my friend’s 740 – 750 call spreads 11% out-of-the-money. Given the elevated volatility of the time there was still about $.75 of premium in the spread. That tempted him to hold the spread the last few days to exploit the rapid time decay. After all, what are the odds the RUT would move 11% in two trading sessions?

Well, never say never because the small cap index proceeded to do just that. In fact the settlement value for September options came in at 771, or 14% higher than where the RUT was two days prior.

That $.75 gain turned into a $10 loss. Due to the huge negative gamma going into expiration a small gain turned into a monumental loss. You want to know the worst part?  The RUT was back down to 676 within one week!

Gamma Catch-22

Gamma brings to traders a Catch-22 of sorts. On the one hand holding short options close to expiration offers quick rewards due to high time decay. On the other hand these short options expose traders to the potential to quickly accumulate losses — often referred to as gamma risk.

Traders that insist on riding their short option positions all the way to expiration in an attempt to capture the last few bucks from a trade often justify their approach by pointing out the elevated rates of time decay eating away at their short. But they forget the elevated gamma risk they face.

For as many times as they enjoy the additional and oft times quick profits they rake in from riding a short into expiration, they will inevitable have to deal with the occasional horror show where the market makes a kamikaze run for their short options.

In the long run, the extra few bucks accumulated from riding to expiration unscathed typically pale in comparison to what’s forked out to pay the piper when those “cheap” short options come back to bite you.

Expiration week is a difficult time for most traders, both the hard-boiled veterans and the guy that may do only a few trades a month. It is almost inevitable that the expiring strikes will mean losses during a trader’s life time. But understanding and applying the Greeks like Theta and Gamma can help reduce those losses and build the gains.

Follow Tyler Craig on Twitter@TylersTrading.


Article printed from InvestorPlace Media, http://investorplace.com/2011/05/greeks-predict-prices-at-options-expiration/.

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