<i>TSC</i> Options Forum: Discovering Alpha - TheStreet

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."

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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.

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.

Another important variable, as always, is implied volatility. Generally speaking, an increase in implied volatility gives an option a lower negative value. For example, if a 35% implied volatility were plugged into the table above, the alpha for the calls when the QQQs are trading at $35 with 15 days remaining drops from -9.31 to -4.78. This illustrates that alpha measures how great an impact the underlying stock's price will have on the option's value. As implied volatility (or time, or any other component) becomes an increasingly large part of the option's value, its alpha contracts or becomes less negative.

In terms of spread strategies, this means that as the alphas of the various strikes converge, you are probably approaching the point of maximum profit (or loss). This is no great revelation, because it's obvious that when all options move deeper into the money, their price will behave similarly.

For back spreads, which consist of buying a multiple amount of out-of the-money options while simultaneously selling a single unit of a further into-the-money strike, this simply tells me the position should be closed out (for a profit, I assume) if all strikes have moved into the money and implied volatility has catapulted higher.

This may seem very simplistic, but sometimes it's best to keep things that way. Unless you're a professional trader or market-maker carrying large positions across multiple strikes and expirations, and you need a quick picture of how all your holdings would react to a change in the underlying price, alpha may be useful. For everyone else, I think the other five Greeks provide ample insight into an option's price behavior.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

Steve Smith.