gamma

Any Car Racing Fans Out There?  Stock Car Race Fans?  Drag Race Fans?

I like to think of Stock trading like Stock Car Racing.  (Convenient?)  Your car races the track at a constant 100 mph. (Delta of 1.00)  As long as you don’t spin out and hit the wall, (drop in price) or take too many pit stops (stagnant price movement), you will win your race and claim the prize of profits in your account.

I like to compare option trading to Drag Racing.  You buy at a point, desiring your option to slingshot in speed to a much higher price.  The quicker the better.

With Stock Racing you have time on your side, a 500 mile course gives you opportunities to get back on top.  Time is also on the side of stock traders.  Stock prices can rise sooner or later.  Sooner being better.  Timing is much more important to the option trader.  In Drag Racing, if you jump the gun they don’t restart the race, you’re red flagged, you lose.  With option trading you need to be not only right, but right on time.

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With Drag Racing and option trading you want to be lined up from the start because there is less room for mistakes.

To win a Stock Car Race you need sustained speed over a long distance.  Winning a Drag Race isn’t based on speed, but acceleration.  The fastest car doesn’t win, the quickest does.

Option trading, like Drag Racing is based on acceleration.

Back to Option Pricing (very necessary to understand for option strategy) :

Delta measures the change of an option relative to the change of the underlying.  Delta is quoted like a snapshot in time, however, it is dynamic.  Delta changes, it responds to the passage of time and to the movement of the underlying asset.  The change of Delta is measured by Gamma.

Beginner option traders have probably never heard of Gamma.  Novice traders might be aware of the term, but don’t understand Gamma’s significance.  Professional option traders and Market Makers understand and trade Gamma.  To a hedge trader, those with large multiple positions, Gamma is the most important component of option pricing.

Knowledge of certain concepts is necessary before attempting to understand Gamma.

Everyone should know what In the Money (ITM), At the Money (ATM), and Out of the Money (OTM) means regarding strike prices.  These terms indicate if an option has any intrinsic value.  Does the option have equity, in addition to potential.  On expiration day, the time is gone, the potential has passed, the only options with value are the In the Money (ITM) options.

Traders buy options hoping the intrinsic value increases, or the extrinsic value decreases.  Extrinsic is the opposite of intrinsic.  Intrinsic measures the amount in the money, extrinsic measures the amount out of the money.

Example:

Let’s say a stock is at $ 20.00, the $ 17.50 call is In the Money (ITM) $ 2.50.  It has $ 2.50 of equity, or intrinsic value.  The $20.00 call has no equity, no intrinsic or extrinsic value, it is At the Money (ATM).  The $ 22.50 call has no equity, no intrinsic value, but the extrinsic value is $ 2.50, it is Out of the Money (OTM).  As a general rule, extrinsic value is not used.  Most traders consider Out of the Money (OTM) options as having zero intrinsic value.  This is true, but you should be aware of the existence of extrinsic values.

If in our example, the stock were to rise to $ 22.50 the $ 17.50 call’s intrinsic value would increase $ 2.50 to $ 5.00.  It is now Deep in the Money (DITM).  The $ 20.00 call would now have intrinsic value.  It changed from At the Money (ATM) to In the Money (ITM).  The $ 22.50 call lost its extrinsic value, it went from Out of the Money (OTM) to being At the Money (ATM).

Delta varies according to the Laws of option pricing.  The more In the Money, the higher the Delta.  As an option’s intrinsic value increases, so does its Delta..  Options with extrinsic values have low Deltas, but as they move from Out of the Money (OTM) towards being In the Money (ITM), their Deltas increase.  The higher the Delta the more dollar for dollar the option moves relative to the underlying.

Gamma measures the rate of change of Delta.  Suppose in our previous example, the $ 20.00 call (ATM) had a Delta of .50 (fifty) if the stock rose $ 2.50, the Delta might rise to .65 (sixty-five) as the option went ITM, the total Gamma would be .15.  Gamma usually shows up in pricing models measuring the change of Delta for a $1.00 move in the underlying.  Simplistically said, the Gamma in our example on the $ 20.00 ATM call was .06.  Delta increased .06 (six) for each $1.00 move of the stock.  2.5 times .06 equals .15.  In reality, the Gamma might have started at a slightly different figure and changed with the stock price.  Don’t worry, there isn’t a “Greek” to measure the rate of change of the rate of change of the rate of change etc.

Delta is speed.  Gamma is acceleration.

I buy options because of Gamma.  I’m a Drag Race fan.

I hope people are getting some useful information from these “Basic” posts.  Don’t worry we will be getting more specific about option strategies especially using weekly options.

 

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