Options trading has given you the bug and though you're not quite ready to put money to work just yet, you're feeling good. You've gotten comfortable with knowing what a call and put are and the next time you're at a dinner party, people will be coming up to you to ask what a strike price is.
You're still understanding some of these basic terms to help you reach success when you hear a friend mention terms like gamma, theta and delta. After you're done freaking out, you realize the "Greeks," as they're collectively known, are actually pretty helpful and can aid you in understanding how sensitive the price of an option is to certain factors.
They're designed to help you understand the risks and rewards of your options, so understanding what they mean is the first step in your journey toward successful option trading.
Here are the three most important Greek terms and the importance behind them that every retail trader should know.
No it's not the airline you went on last week to visit your Aunt Gladys in Boca Raton -- delta is the share equivalent of your options position. This means that if you own a call or a put, it's the number of shares you're long or short.
If an option has 50 delta, it's essentially the same thing as owning 500 shares, says Adam Warner, author of Options Volatility Trading.
Theta Theta is the time decay, or the amount of value your option loses as time goes on. As the option -- be it a put or a call -- gets closer to the expiration date, the value gets lower over time. Why is that? Simple, says Warner. "The more time an option has, more possible outcomes and it can move more," he says. "An option with more time can move more then an option with less time."
Why is it so important to understand? It's due to helping hedge (or limiting your exposure), says RealMoneyPro contributor Timothy Collins. "Often, new traders will incorrectly assume one option contract will provide the same exposure as buying 100 shares of a certain stock," he says. "An understanding of delta is critical in selecting the appropriate number of contracts to hedge the desired exposure."
Gamma may have been made famous thanks to Bruce Banner and the Hulk, but it's actually really important when it comes to options trading.
It's essentially the rate of change of your delta, says Warner. "If gamma is 100 and the stock goes up $1, the delta would be 600, so now you own the equivalent of 600 shares."
Traders should be cautious, though, because gamma isn't a straight line. As a result, it's important to know that a position can become more bullish or bearish as the value of change occurs, Collins notes. "If a trader doesn't understand this, they may find themselves far more exposed in the market than they intended," he says.
Despite what you thought, theta isn't the name of the fraternity or sorority you were in in college -- it's about time and the impact it has on options.
Time decay may be the single most important concept to understand in options trading, Collins notes, because of how much it can impact potential profits. "Theta is often the crusher of profits in option trading for buyers," Collins says. "It is important to understand the impact the clock has on your position and potential profits."
Understanding delta, gamma and theta are crucial for options traders and it's important to realize the impact they'll have on your portfolio. They'll help increase your chances for profit, while helping you sound like a Wall Street hotshot all in the same.