When beginning your journey into options trading, there are option trading-specific measures that are important to understand before you start trading. These measurements are primarily used to evaluate the performance of your options account.
In fact, you’ll discover that there is a myriad of strategies that revolve specifically around many of these measurement tools.
To be clear, not all options trading strategies require an in-depth knowledge of all these measurements, but in our opinion, it’s folly not to have a basic understanding of the most prominent of them prior to trading options.
There are many more measures used with options trading, specifically within “The Greeks”, and covering all of them would be outside the scope of this article. However, for most retail traders there’s really only a handful that you’ll encounter, find important, and use in your day-to-day trading.
The basic option trading measures and Greeks we’ll cover in this article are:
Margin
Maintenance Margin
P&L
Equity
Delta
Gamma
Theta
Vega
Volatility
MARGIN
Margin is simply the amount of money (collateral), whether it’s USD, Euros, BTC, etc., that a trader or investor has to deposit with their broker or exchange to cover the credit risk that the holder poses to the broker or exchange.
Margin requirements will vary depending on the asset being held. Requirements for stocks are different than for equity options, cryptocurrency options, or for futures contracts for example.
When trading through a traditional brokerage account, each broker will have a specific requirement for the amount of money needed in the account.
Certain types of trading also come with individual requirements. An example would be where an account holder is authorized to sell naked options. This would require higher levels of margin due to the increased risk to the broker.
Most, if not all trading platforms will prominently display margin use directly on the interface, so it should never be a mystery to the account holder where their current margin use is at.
While using defined risk strategies, margin use won’t change much, but when using unlimited risk strategies, margin can get gobbled up very quickly when the underlying asset moves in price.
As far as option trading measures go, monitoring and managing margin, especially for small accounts is nothing short of vital.
MAINTENANCE MARGIN
Maintenance Margin is a component of the overall margin and is the margin required to maintain current positions being held in an account.
If the margin balance falls below Maintenance Margin requirements, brokerages and exchanges may limit the ability to open new orders unless those orders improve margin use, and existing positions may be incrementally liquidated until the maintenance margin is lower than the margin balance.
Both margin and maintenance margin is usually shown on trading platforms at both an account and a position level.
Margin use can fluctuate as the underlying asset changes in price, based on any open positions.
As traders, ultimately we want to use as little margin as possible to achieve our trading goals, and margin is something that should be monitored continually.
The Rogue Trader Academy's rule of thumb regarding margin use is to keep margin below 30% under normal trading conditions. In the event of significant underlying price movements, margin use can get gobbled up quickly, so by maintaining a good amount of available margin, we’re able to keep some “powder dry” so to speak.
This allows us to take advantage of, and make adjustments to trades vs. having our hands tied due to having little or no available margin.
Too often new traders don’t fully understand how price swings in the underlying asset can affect margin, causing them to make poor strategy decisions, leading to unnecessary margin complications. This is one of the reasons why we teach, and are advocates of lower-margin, defined risk strategies for new traders as they learn to trade the options markets.
PNL
PNL, P&L, or Profit and Loss is the profit or loss of a position(s) at the current market price.
As the market moves, your PNL will fluctuate. It can be viewed as your “scorecard” at any given moment. If you're a newer trader try not to get fixated on watching your PNL fluctuate and giving yourself too much anxiety.
It's an important option trading measure, but you'll just have to accept that it's going to move around.
EQUITY
Equity is how much money (currency) you have in your account. Basically the balance, plus or minus any profit or loss from open positions.
If a trader had no open positions, the equity would equal the balance of the account. The equity of the account will fluctuate as the underlying price moves around and the value of any open positions change.
OPTION TRADING MEASURES: THE PRIMARY GREEKS
DELTA
By definition, delta is the rate of change of an options price given a $1 increase in the underlying price.
Delta is concerned with direction and there are 4 primary ways we use delta at Rogue Trader Academy, making it an indispensable market measure when trading options:
- Gauging the rate of change of an options price
- Knowing the probability of an option expiring ITM (In The Money)
- An indicator of directional risk
- Hedging tool for positions or portfolios
Gauging the rate of change of an options price:
Deltas can be either positive or negative.
Call options have a positive delta between 0 and 1, while put options have a negative delta between 0 and -1.
A 0.20 delta option, for example, will change about $0.20 for every $1 move in the underlying.
A 0.50 delta option will change about $0.50 for every $1 move in the underlying, and a 1 delta option will move about $1 for every $1 move in the underlying.
Delta tells us how fast the price of our option will change or how much “traction” it will have as the underlying price moves, and thus the risk/reward we can expect from our option given underlying price changes.
Knowing the probability of an option expiring ITM (in the money):
Using delta as a probability gauge is one the primary ways we use delta, and one of the easiest concepts to understand.
Let’s look at a call option with a 0.30 delta, commonly referred to as a 30 delta call.
If we were to buy this option, at that moment the delta is telling us that it has a 30% chance of expiring ITM. As a call buyer, generally, we would want this option to expire ITM.
For every buyer there’s a seller, so let’s look at this from an option seller’s (selling to open) point of view.
If we sold this option, and just as for the buyer, at that moment the delta is telling us that there’s a 30% chance the option will expire ITM (as an option seller, we generally wouldn’t want the option to expire ITM).
Delta is simultaneously telling us that there’s a 70% chance that the option will expire OTM (Out of The Money). Having the option expire OTM means that, as sellers of this option, we would keep all of the premium we received when we sold the option.
Note that we rarely hold options to expiry for a host of reasons, but we’re simply demonstrating here the basic concepts for ease of understanding.
It’s clear that at a glance, and at that moment in time, delta is measuring and will tell you exactly what the probability is of an individual option expiring ITM or OTM, or in other words, the odds of you “winning” on that trade.
On a related note, one can see that the delta of an option will also guide its price because of the probability of that option expiring ITM.
For example, if I sell a 0.40 delta call option, it will fetch more premium (I’ll get paid more) than a 0.30 delta call option. Why? Because the 0.40 delta call option has a higher probability (40%) of expiring ITM (the option’s strike price is closer to the price of the underlying asset than the 0.30 delta option is).
An indicator of directional risk:
When looking at any position or a portfolio, at a glance, one can instantly recognize the directional risk and how the equity of the account will be affected by price changes of the underlying asset(s).
If the delta is positive, the directional risk is to the downside (if the underlying asset price decreases). If the delta is negative, the directional risk is to the upside (if the underlying asset price increases).
The larger the delta, the larger the risk.
If I had an open position with a 0.5 delta, underlying price movements are going to affect me or “feel” like I’m carrying 0.5 of the underlying asset.
Let’s say this was a BTC call option for example, that 0.5 delta call option will “affect” the equity in my account as if I was carrying or was “long” 0.5 of a BTC.
If it was an MSFT call option, the underlying price movement would affect me like I was carrying 50 shares of MSFT (stock options have a 100 multiplier effect because each option contract typically represents 100 shares of the underlying stock).
Hedging positions or portfolios:
You may have heard the term “delta neutral”. This means that a position or a portfolio has a zero, or near zero delta. Indicating that movements in the underlying price, whether up or down, will not affect the equity of the account (you have little risk regardless of price movement).
There is a myriad of ways to hedge (minimizing risk) and it’s a very common application of use with options. One can think of it as identifying the direction of the risk (is the delta positive or negative), and then applying opposing delta strategies to push the delta value closer, or to zero.
The table below displays some simple naked positions and their directional risk.
For example, holding a long call is going to be delta delta-positive position. To negate that positive delta, we would apply some negative delta to minimize or hedge that risk such as selling a call or buying a put option.
Delta hedging with options is dynamic. It’s dynamic because as we’ve seen above, the delta is constantly changing as the underlying asset price changes. Therefore the hedge may require constant adjustment as well.
GAMMA
Gamma is the rate of change of delta, given a $1 move in the underlying asset’s price.
You can think of it like a moving vehicle where the speed of the car is the delta, the acceleration would be its gamma.
Let’s say that we had an ITM long call with a delta of 0.70 and the gamma was .05.
If the price of the underlying went up by $1, the delta of the call option would change to 0.75.
We knew what effect that $1 increase would have thanks to gamma.
Long options have positive gamma and short options have negative gamma.
Gamma generally works in favour of options buyers, especially as the price moves in their favour, and generally works against options sellers.
It’s interesting and important to note that gamma increases as an option nears expiry. You may have heard the term “gamma risk”, making this an especially important option trading measure for specific trading strategies
Using the above example of a call option with a .05 gamma, that gamma may rise to something like .20 in the final days prior to the option expiry. This makes them much more sensitive to movements in the underlying asset price and therefore riskier.
As a general rule of thumb, we rarely hold options to expiry, tail-end gamma risk being one of the primary reasons.
THETA
Theta is the rate of decay of an option's price with the passage of one day.
Because options have an expiration date, each day closer to that expiration an option will lose some of its time or extrinsic value until finally reaching zero time value at expiration.
This just makes sense because with the passage of each day, there’s less time for the option to move around before it expires.
The daily loss of an option’s extrinsic value is time decay or theta decay.
Unlike some of the other Greeks, theta is measured in currency. So one is able to see approximately how much they’re “making” or “losing” each day in theta decay.
Theta is negative for long options and positive for short options.
Theta is an options seller's best friend and an trading measure that sellers keep a daily eye on, because the seller of the option is hoping to sell and then buy that option back at a lower price (sell high, buy low), or have it expire worthlessly, in which case the seller would retain 100% of the premium received.
As you’d imagine, theta works against option buyers. When an option is purchased (long), as that option ages and gets closer to expiration, it will lose its extrinsic or time value, so one can think of a long option as a wasting asset.
VEGA
Vega measures the rate of change in an option's theoretical value given a 1% change in implied volatility (covered below).
Long options have positive vega whereas short options have negative vega.
Generally speaking, when volatility rises, an option’s price will rise. When volatility falls, an option’s price will fall.
If I’ve bought (long) an option, I would typically want volatility to increase, with the expectation of the option’s price rising as well, allowing me to sell it for a higher price than purchased (buy low, sell high).
If I’ve sold (short) an option, I would typically want volatility to decrease, with the expectation that the option’s price decreases as well, allowing me to buy it back at a lower price than it was sold at (sell high, buy low).
Consider the example where I bought a call option that was currently trading at $5 and had a .30 vega.
If IV (Implied Volatility) increases by 1%, I would expect the price of the call to rise by about 30 cents, making the call now worth $5.30.
One could therefore say that vega is measuring our IV exposure.
When looking at underlying assets that have a history of volatility and a high vega, it’s easy to see how quickly a jump in IV by even 5 or 10% for example, can quickly and significantly move an options price.
VOLATILITY
While not one of the Greeks, volatility, and IV (Implied Volatility) are extremely important to understand and are primary factors in an option’s price. We can think about volatility as a measure of fear and the likelihood that prices will change.
Volatility is typically expressed as historical volatility and Implied Volatility (IV).
Historical volatility is…well, historical. It’s the standard deviation of daily price moves expressed annually, whereas IV is the current market participants' view of the likelihood of changes in any given asset’s prices.
In this article, we can’t go “deep” into volatility and its related topics such as skew, the Black Scholes pricing models, volatility surfaces, etc., because they’re beyond the scope of necessity for both beginning options traders and the trading activity of the average retail trader.
Suffice it to say though that historical volatility is based on the past and implied volatility is the “now”, based on the sum of all trader sentiment, and is the only number that “matters” because it is what shapes the price you will receive or pay.
OPTION TRADING MEASURES SUMMARY
This article might have been a lot of information to take in for those just beginning their options trading journey.
However, these are arguably the most important and most common metrics you’ll see on a day-to-day basis, and understanding them is vital.
Like anything, the more you understand and see these metrics at work, the more fluent and easily you will interpret and use them.
