• An increase in volatility will increase an option premium
• An increase in time-to-expiration will increase the premium
• An increase in the underlying share price will increase an option’s price
• A decrease in the above factors will result in a decrease in option value.

The major Greeks:

Delta: Price sensitivity. The most commonly used greek measures how much the theoretical value of an option will change if the underlying value of the stock moves up or down $1. The delta of a call can range from 0.00 to 1.00. The closer an option’s delta is to 1.00, the more the price of the option responds like the underlying stock, when the stock price moves. For example, if company BCI is trading at $38/shares and the $40 call is selling for $2, with a delta of .50, the following would be true if all other factors remain constant:

• If BCI increases to $39/ share, the $40 call would increase in value to $2.50
• If BCI decreases in value to $37/share, the $40 call would decrease in value to $1.50
• In other words, for every change of $1 in share price the option value changes by one half that amount.

Gamma: Second order price sensitivity. The rate of change for delta with respect to the price of the underlying security. It is an estimate of how much the delta of an option changes when the price of the stock moves $1. When an option is deep in-the-money or deep out-of-the-money (several strikes above or below the market value of the stock), the gamma is small. When the option is near the money, the gamma is the largest. Gamma is used when trying to gauge the price of an option relative to the amount it is in or out of the money.

Theta: Time sensitivity. It is a measure of the rate of decline of an option due to the pasage of time. An option will lose value as it moves closer to expiration Friday if all other parameters remain constant. Theta has a greater impact on options with fewer days to expiration than those with more days to expiration. You will note on the charts presented in my most recent book, Exit Strategies for Covered Call Writing, the option value literally falling off a cliff towards the end of the contract period. This is theta at work. Theta will NOT impact intrinsic value, but rather the extrinsic or time value.

Vega (the only “Greek” not represented by a real greek letter): Volatility sensitivity. The amount that the price of an option changes compared to a 1% change in volatility. Higher volatility means higher option prices. This is because the greater volatility brings with it larger price swings and more likelihood of an option to make money. Vega is highest for A-T-M calls and lower as options delve deeper I-T-M and O-T-M. Vega also falls as the option gets closer to expiration.

Practical application:

1- Delta and Gamma are first and second order price sensitivity measures. When a strike is in-the-money, the delta is about 1.00. A move up of $1 in price will represent  another dollar of downside protection. A decline in share price of $1 will decrease our protection by that same amount. If we are especially concerned about a declining share price or market volatility, we may want to get as deep in the money as possible (still receiving a decent return), since protection erodes dollar for dollar of intrinsic value at these levels. To review the option premium formula:

Premium = Intrinsic value (amount in-the-money) + time value (including volatility)

2- Theta represents time sensitivity. Since we are selling predominently 1-month options, time is limited to begin with. During the final two weeks of a contract period, option value literally falls off a cliff. It’s difficult to generate the kinds of returns we are seeking if we wait for the final two weeks. Because of the threat of theta, we should look to sell our options during the first week of a 4-week contract period and the first two weeks of a 5-week contract period. Theta is also the reason I created the rules of paying less to buy back an option during the latter part of the contract cycle than in the earlier portion of that time frame when executing exit strategies.

3- Vega represents volatility sensitivity. We all love great, big, juicy returns. The more the better, right? WRONG!

If delta, gamma and theta remain constant but the option premium returns much more than the 2-4% per month we seek, we know vega is rearing its ugly head. Volatility means risk. The stock can go up a lot but it also can decline dramatically in a short period of time. When I see a 6-7% 1-month return for a 1-month option, I check the chart and usually see a major roller-coaster pattern. No thank you, I’ll pass for the steady uptrending safer moving averages. Many of you who read, Cashing in on Covered Calls, may remember my story about Taser and how I learned my lesson to avoid these volatile companies.

The bottom line is that it’s not essential to memorize the definitions of the greeks (unless you’re going to appear on Jeopardy). It is helpful, however, to understand the concepts of how price, time and volatility play into the value of our option premiums and what that says about the nature of the underlying equities.

Last Weeks Economic News:

The impact of the global recession and lower energy prices were reflected in lower consumer prices and industrial production (down by 1.1% in May). Signs of recovery, however, included a surge in new residential construction (up 17.2%) and a rise in the Conference Board’s index of leading economic indicators (up 1.2% in May). For the week, the S&P 500 declined by 2.6% for a year-to-date return of 3.3%.

Stocks on the Move:

On the home page of the IBD website is a list called Stocks on the Move. These are stocks that were up in value for the day on higher than normal volume. This is oftentimes indicative of the institutional players taking positions in these equities. This is of great interest to us as we would like to join the party. Three of the stocks from Fridays list met our system criteria:

• FUQI
• PWRD
• TNDM

FUQI was already on my watchlist so I added the other two.  Here is the chart of FUQI as of the penning of this article:

FUQI as of 6-19-09

Looking at FUQI, I noticed some interesting option choices.If we purchased this stock near closing on Friday, we would pay $17.63. Usually, we would look to the $17.50 strike:

ROO = 190 - 13/1750 = 10%

Downside protection = 13/1763 is negligible.

This return reminds us of the above discussion of vega. The market is expecting volatility with this equity perhaps because of the huge run-up it has had lately.  How can we reduce this risk and still use this financial soldier? I checked the $15 call:

ROO = 330 – 263/1500 = 4.5% 1-month return = 54% annualized

Downside Protection = 263/1763 = 15%

With vega telling us that we are prone to a volatile, risky investment, why not go for the still great 4.5% 1-month return and a fabulous 15% insurance policy (paid for by the option buyer!).

Videos now playing on the homepage:

What Option Premiums Tell us about the Underlying Stock and more….

My best to all,

Alan (alan@thebluecollarinvestor.com)