Financial Risk Variables: The Greeks in High-Powered Investing
When you trade options, you need to understand the Greeks. So-called because the most common of these tools are represented by Greek letters, the Greeks provide investors with a way to calculate risks that affect the value of their portfolios. They can then use this information to mitigate, or hedge, their portfolios against adverse market conditions. The Greeks explain several risk variables that influence option prices:
Amount of volatility: An increase in volatility usually is positive for put and call options, if you’re long in the option. If you’re the writer of the option, an increase in volatility is negative.
Changes in the time to expiration: Time value shrinks as an option approaches expiration and is zero upon expiration of the option. The closer you get to the time of expiration, the more negative the time factor becomes for a holder of the option and the less your potential for profit.
Changes in the price of the underlying asset: An increase in the price of the underlying asset usually is a positive influence on the price of a call option. A decrease in the price of the underlying instrument usually is positive for put options.
Interest rates: Higher interest rates make call options more expensive and put options less expensive, in general.
By understanding the Greeks, which follow, you’ll be better able to protect the value of your portfolio.
Alpha (Α, α): Investment return that’s different than you’d expect, given an investment’s beta, which is its exposure to market risk and return. Alpha (which can be positive or negative) describes an intangible value that accounts for the extra return generated (or lost) for the amount of risk taken. Some researchers aren’t sure that alpha exists at all.
Beta (Β, β): The market beta is 1, so an investment with a beta of more than 1 is more volatile than the market as a whole. You can expect the investment to return more than the market in an up year and less than the market in a down year.
Delta (Δ, δ): The percentage change in an investment. Delta often describes how much an option changes in price when its underlying security changes in price.
Gamma (Γ, γ): The rate of change in delta. Gamma is exposure to any change in price, positive or negative.
Sigma (Σ, σ): Standard deviation, or the likelihood that any one number in a series — like a series of investment returns — will be different from the return that you expect. The higher the standard deviation, the greater the investment risk.