Options can be a very challenging concept for investors to get their minds around, particularly given some of the complex math involved in trading and hedging positions. Before we even get going, rest assured in this piece there will be no math. Rather, what we would like to do is provide an educational piece about the different components of how options are priced, to help folks better understand these securities and reduce the confusion that tends to accompany options. We also want to do this while having some fun, with that in mind we are going to use Formula One racing to translate option “Greeks” and help explain how they behave in various market environments.
For the uninitiated, Formula One racing is highly entertaining. Netflix’s Drive to Survive is a fantastic way to get introduced to the sport and has been quite the crowd pleaser when my wife and I can’t figure out what to watch after both our toddler and dog have finally called it a day. Essentially these are some of the fastest racing vehicles on Earth and the engineering/precision required to drive the cars to their absolute limit is thrilling. Along with that, the politicking and drama between the teams is completely over the top and hilarious. Yes, we are going to talk options Greeks, but we are going to try to have a good time doing it.
First, what the heck is a “Greek”? Greeks come from the Black-Scholes model which was first posited to price options back in 1973. Myron Scholes, Fischer Black, and Robert Merton were awarded the Nobel Prize in Economics in 1997 for their work in this area. The model sits at the heart of how market makers price options, and the Greeks are the individual components to that pricing. There are five main Greeks that can be used to examine the current pricing of an option: Delta, Gamma, Vega, Rho, and Theta. Granted there are many secondary Greeks like Vomma, Vanna, and Charm but we’ll leave those to the people that really enjoy rabbit holes. From here, we’ll use Formula One analogies to hopefully demystify these components to help people better understand how their positions are impacted by market movements.
Delta
Delta measures the change in the price of an option given a $1.00 change in the price of the underlying stock. Delta is positive if you are long a call option and negative if you are long a put option. If you were in Lando Norris’s McLaren, delta would measure the change in speed of the car given the amount of additional pressure you put on the accelerator (calls) or brakes (puts). To put it simply delta is looking at change, and once an option goes “into the money” (the stock goes above the strike price on a call or below the strike on a put), delta then just sits at 1 (or -1 for puts). The way to think about that is akin to the ultimate top speed of an F1 car, once reached the car cannot go any faster no matter how hard you press on the gas.
Gamma
Ok, we cheated a little bit here because technically gamma is a “sub-Greek” off of delta but we’ll set that aside as gamma is critical to understanding the price behavior of options. Gamma measures the rate of change in delta for every 1$ move in the underlying stock. Think of gamma as the rate of acceleration in Lando’s McLaren, where delta measures the change in speed from say 150mph to 200mph (so the delta is 50mph), gamma is measuring how quickly that change occurred. Balancing gamma and delta in an options position is akin to figuring out the proper balance between acceleration and top line speed on a racetrack. Some F1 teams prefer to maximize top line speed (delta) and win the race on the straightaways while other teams may be willing to sacrifice top end speed to gain acceleration (gamma) and seek to out race their opponents on the turns. Both approaches can win, you just need to know which style works best for you.
Vega
This one is measuring the option price’s response to a change in the volatility market makers are pricing into the option. If vega is increasing, that will benefit the person who is long the option. Why? Because if volatility is going up then the option has a greater probability of finishing in the money. In an F1 race, vega would measure the number of crashes that are occurring. More crashes are better for the vehicles that escape because you are now racing against fewer cars and are more likely to win. Formula One tends to have a couple of teams that dominate each year with the lesser teams much less likely to win a given race. If there are fewer crashes (low vega), the dominant teams have a much higher probability of winning. On the other hand, crashes inject a good deal of uncertainty, and a high vega race gives the lower teams a much better shot at ending up on the podium. Think of options sellers like the Red Bull or Mercedes teams, most options expire worthless, and options sellers usually just collect their premiums (win) and move on. However, if volatility (vega) suddenly blows out then you have a scenario where those who purchased the option suddenly find themselves with a tidy profit. One unexpected way vega impacts options are scenarios where market volatility picks up dramatically, markets crater out, and yet if you own long calls they aren’t falling as much as you expected they would. That is because volatility is high, and your call still retains enough of a chance to finish in the money therefore the position still retains some value.
Theta
Theta measures the impact on price as an option moves closer to expiration. If you are an option seller, theta decay is positive for you as your short position has less time to go into the money. If you are a buyer, the more time you want to have in an option position, the more you’ll have to pay. Theta is negative for you, as you move closer to expiration then less time is embedded in your option. That reduces the probability you finish in the money, which reduces the ultimate value of the position. If Max Verstappen is leading the Monaco Grand Prix, then Max would prefer to have fewer laps left to the end of the race as that increases his chances of finishing P1. If you are George Russell in the Mercedes trying to catch him, you would want as many laps as possible to increase your odds of an overtake.
Rho
Ok, last one and kindly note that we kept our promise of no math. Rho measures the change in the price of an option given a 1% change in interest rates. Rho has a greater impact on longer dated options and is much less important for shorter dated options. Think of rho as the overall conditions on the track. When track conditions are such that the tires are worn out more quickly, that increases the number of pit stops necessary to complete the race and potential tire blow outs. High rates (rho) mean rougher track conditions. That doesn’t impact a 10-lap race all that much, but if we’re talking about 60-laps then your team needs to be very thoughtful about which tires to put on the car at the start and how many stops they plan to execute throughout the race.
Hopefully this piece has been somewhat helpful in demystifying how to think about options positioning in a portfolio. Unless you are actively trading an options portfolio yourself, you really don’t need to worry about the math. As with F1 racing, mastering options trading requires a deep understanding of the underlying mechanics, constant adaptation to changing conditions, and a strategic approach to risk management. Ultimately, while options trading may seem as daunting as piloting an F1 car at breakneck speeds, with the right knowledge and tools, investors can navigate this complex financial landscape with greater confidence and precision.
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