TSC Options Forum: Discovering Alpha

I just read your "straddle" article and was wondering whether it was from you or somewhere else that I read about a new Greek, "alpha," that purports to identify the option strike/expire combination with the most leverage for a given amount of risk. It would be great if you could do a forum article on how alpha could be used both for outright put/call selection and/or fine-tuning various directional spread strategies through the back spreads.

Thanks,

-- TGH

I appreciate this question for two reasons: Not only did the reader bring up a new and interesting topic (I admitted to him that I'm not familiar with alpha, but guessed it must be a derivative of other "Greeks" invented to describe the behavior of options price), but after my promise to investigate it for this weekend's Forum, he wisely took it upon himself to explore the link provided in the column, which prompted his original question. He was then kind enough to pass the following definition along. Remember: all it takes is one click and we all benefit:

Steve -- here's what I received from iVolatility.com in reply to my question: "Thank you for interest to our site! Alpha compares the position's profit/loss due to two factors: underlying price change and option time value decay. Commonly, you would wish to have this value negative and large for positive gamma, and small for negative gamma."

Tell Me More

While this doesn't completely answer the original multifaceted and nuanced question, it at least gives us a running start, and leads us to the providing of this straightforward definition: Alpha is the ratio of gamma over theta.

Gamma is the rate of change in an option's delta for one unit move in price, and theta is the rate of change in an options price for one unit change in time. Let's use a QQQ call option with a $35 strike and an implied volatility of 25% to calculate alpha across different prices and time frames, and try to decipher its meaning.

Alpha for QQQ 35 Call Option
Price	35 days	15 days	5 days
$36	-8.58	-8.66	-8.68
$35	-9.19	-9.31	-9.40
$34	-9.82	-9.93	-10.09
Source: TSC Research

As you can see, an option's alpha becomes increasingly negative as it moves deeper into the money. And note how the reduction of time has a much greater impact on options that are in the money vs. those that are out of the money. This is essentially a reflection of the option's intrinsic value, or that an option's delta increases as it moves into the money and its time premium component diminishes. Because an out-of-the-money option has no intrinsic value, it makes sense that time decay will have less impact to its rate of change relative to a move in price.