The concept of a stock option is fairly straightforward: It provides the right or obligation to buy or sell a stock at a specified time and price. Of course, the price of an option is influenced by a wide range of factors, including the underlying stock price, time remaining, volatility and even interest rates. These factors are often represented with so-called “Greeks”.
Covered calls are a fairly straightforward strategy that investors can use to generate an income from long stocks in their portfolio, but it helps to understand options on a deeper level in order to handle any unexpected turn of events and maximize the profitability of each trade.
Let’s take a look at the most popular Greeks that affect covered call options in order to better understand how option prices change over time.
What Are the “Greeks”?
The price of an option is influenced by a variety of factors that are commonly known as “Greeks” since most of the factors are named after Greek letters. When analyzing options, the Greeks help investors understand the risks related to an option or option strategy, as well as help manage a trade over time as risk factors evolve.
|Major Greeks||Minor Greeks|
In addition to the Greeks, many investors look at implied volatility, or IV, which is the estimated volatility of an underlying stock based on the price of the stock option. Implied volatility can be helpful to estimate potential volatility in an underlying stock, or conversely, determine whether a stock option is fairly valued by comparing it to historical volatility.
The mathematical formulas used to compute option Greeks are fairly in-depth since they use derivatives and other advanced mathematics. Fortunately, most option brokerages and many financial websites compute the major Greek values for you. NASDAQ.com (pictured below) shows the option Greeks within a straddle list.
Option Chain Greeks Example – Source: NASDAQ.com
The next four sections will take a look at the most popular option Greeks and how you can use them to better understand covered call opportunities and positions.
Delta: Price Sensitivity
Delta measures how much an option’s price is expected to change per $1.00 change in the price of the underlying stock. For example, a Delta of 0.50 means that the option’s price will theoretically move $0.50 for every $1.00 move in the price of the underlying stock. The popular Greek can help you better understand the probability and price impact of stock movements.
When investing in covered calls, Delta tells you the probability that the option will expire in-the-money. A delta of 0.25 means that the option has a 25% chance of being in-the-money at expiration. Most covered call investors seek to avoid in-the-money expirations since they would be required to buy back the option or deliver the underlying stock.
Gamma: Rate of Change
Gamma measures the rate of change in an option’s Delta per $1.00 change in the price of the underlying stock. For example, suppose that the Delta of 0.50 above changes to 0.60 when the price moves higher the next day. The Gamma of 0.10 (0.60 – 0.50) suggests that the Delta has changed 0.10, which can be helpful when you average them over time.
In practice, Delta only tells you the probability that an option will expire in-the-money at a given point in time. Gamma can help you understand how Delta is changing over time, so you can determine the likelihood of an in-the-money expiration over time. A higher Gamma translates to a greater risk that the option will expire in-the-money.
Theta: Time Decay
Theta measures the change in the price of an option for a one-day decrease in its time to expiration. In other words, it shows you how much the price of an option will theoretically decrease as the option nears expiration. For example, an option that’s far out-of-the-money or far in-the-money will have a more linear Theta than an at-the-money option.
Covered call investors benefit from Theta, or time-decay, since it decreases the likelihood that the option will be exercised. Understanding Theta can help investors close positions at the ideal time and maximize the amount of value captured, particularly when a covered call position may need to be closed prior to the expiration of the contract. Since the time-decay accelerates as an option approaches expiration, most covered call investors focus on short-term expirations.
Vega: Volatility Sensitivity
Vega measures the rate of change in an option’s price per 1% change in the implied volatility of the underlying stock. While it isn’t technically a Greek letter, volatility is one of the most important factors influencing option prices. A drop in Vega causes both calls and puts to lose value and vice versa for an increase in Vega.
When using covered calls, Vega can help you avoid overpaying when establishing a position. Investors can capture the most value when selling call options when Vega is higher than normal levels and closing positions when Vega is lower than normal levels. Investors can determine this by comparing the historical volatility to the implied volatility.
The Bottom Line
Stock options are easy to trade and understand but challenging to master due to the sheer number of factors influencing their price. By understanding the Greeks, you can quickly understand these factors at a glance, including everything from volatility to time decay.
If you’re interested in covered calls, the Snider Investment Method provides a done-for-you system designed to maximize income from covered call positions. The Lattco platform makes it easy to screen for covered call opportunities, as well as manage your positions over time. Sign up today for a free e-course or contact us to learn about asset management options.