If you have made it over to the Portfolio Page on our site, you should check it out.  It has our picks of insurance stocks, and it will track the portfolio’s gains and losses.  As of yesterday, we have been beating the S&P500 by over 3.5%.  While it is only a short period of time, you might want to look into these companies.

We update our portfolio weekly, so check back often!

- Robert

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To add to our continued series on using Thinkorswim to analyze the option Greeks, we will look at Theta, or the time decay factor.

If you need to refer to the other posts, here they are: Delta and Gamma.

Theta – Theta is an estimate of how much the theoretical value of an option decreases when 1 day passes and there is no change in the underlying stock price or volatility.  Theta is used to estimate how much an option’s value decreases as time passes.  Long calls and puts always have negative theta, and short calls and short puts have positive theta.  The stock itself has zero theta, as its value is not constrained by an expiration date.

Theta doesn’t reduce an option’s value at an even rate.  Theta has much more impact as an option nears expiration, since there is less time to realize a move in the underlying stock.  Theta is highest for ATM options, and is progressively lower as options are ITM or OTM.  The theta of options is also lower when there is less volatility, or more days to expiration.

There is a trade-off between gamma and theta.  Options that have the highest gamma also have the highest theta.

In the example below, we take the same SPX Sept10 1090 call from the past examples, and we skip forward in time by 1 trading day.  Here was the previous example:

ThinkorSwimSPXSept10

In the example above, theta is -38.59.  It has the highest gamma, and as a result, it also has the highest theta.  It is the highest because it is barely ITM.  If we skip forward 12 hours to the beginning of the next trading day, you can see that the price of the option has not changed (the market hasn’t opened yet), but theta and gamma have both increased.

I hope this illustrates the importance of theta and the time value of options.

- Robert

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Now that we have covered delta in our previous post: Thinkorswim: Terminology – Delta, it is time to take a look at how much delta moves when the price of a stock changes.  This measure is called Gamma.

Gamma – Gamma is the estimate of how much the delta of an option changes when the price of the underlying stock moves $1.00.  Gamma essentially tells you how stable your delta is.  A big gamma indicates that your delta can change dramatically even if the underlying stock only moves slightly.  Long calls and puts always have positive gamma, while short calls and puts always have negative gamma.  Positive gamma means that the delta of long calls will become more positive as the underlying stock price rises, and move towards 0.00 as the underlying stock price falls.

Using the same example from Thinkorswim: Terminology – Delta, the SPX Sept10 1090 call has a delta of +0.5408 and a gamma of 0.69.  If the SPX moves up $1.00 to $1,095.16, the delta of the call would become 0.91 (+.5408 + ($1 * 0.69)).  However, gamma is always highest when the call is at the money.  So, you delta jumps closer to one, but gamma would drop as the call moves into-the-money.  In practice, the delta of 0.91 makes sense, but in reality, it would rise, but not that high.  Other factors, such as volatility, play a role as well.

Basically, what a trader wants to look for is a position with positive gamma because a position with positive gamma is relatively safe as it will generate deltas as the stock moves.  A position with negative gamma will generate deltas that will hurt your position.  Gamma is a good reason to look at the Analysis page in Thinkorswim.

ThinkorSwimSPXSept10

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Now that we have covered the basics of options, it is important to understand how they act.  The main terminology behind their behaviors take us back to high school physics, where we utilize the Greeks: delta, gamma, theta, and vega (not really a Greek letter, but it works).

This time, we will focus on delta!

Delta – The delta is a theoretical number that measures how much the value of the option will change if the underlying stock moves up or down $1.00.  A positive delta means that the option position will rise in value if the stock price rises, and fall in value if the stock price falls (usually a call).  A negative delta means the opposite, that the option value will rise with a decline in the underlying stock price (usually a put).  The delta can range from 0.00 to 1.00 for a call, and 0.00 to -1.00 for a put.  The closer to 1.00 or -1.00, the more the price of the option responds like the underlying stock.  However, this assumes that nothing else changes – such as volatility, interest rates, or time.  Any of these can change delta even if the price of the stock remains the same.  Also, the more ATM the option is, the closer its delta is to 0.50.  The more ITM, the closer to 1.00, and the more OTM, the closer to 0.00.

On the Thinkorswim platform, delta is presented in terms of shares of stock, with 1 call representing 100 shares of stock.  So if delta is +.75, the platform will show a delta of +75.  In our example below, the Sept10 1090 call has a delta of 54.08, which really would be +.5408.

So, as of 8/18/10, the Sept10 1090 call has an ask of $26.80.  If we would buy that call at $26.80, the delta would be +.5408.  The current underlying price is $1,094.16.  Theoretically, if all else is the same (volatility, interest rates, dividends, and time), if the price moved to $1095.16, the price of the option should move to $27.34.

Also, you can see, that as the option moves more into the money (as illustrated by the +5% hypothetical), the delta increases closer to 1.00.

So delta is an important measure because it is a gauge of how much your option will gain in value given underlying stock changes relative to the strike price.

ThinkorSwimSPXSept10

- Robert

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I think most College Investors are interested in options trading.  As I have mentioned before, I believe the best platform to do this is Thinkorswim.  If you want to understand more about Thinkorswim, check out my post on it here.  Over the next few weeks, I really want to deep dive into how to trade options, and how to do it in Thinkorswim.  But first off, lets start with the basics.

The building blocks of all options trades:

Call – The option to buy a stock at a given price

Put – The option to sell a stock at a given price

Long Call – Strategy used if you think a stock’s price will rise before the expiration of the option.  Generally seen as less risky than buying the stock, but it is important to remember that options expire and stocks do not.  You can sit on a stock forever waiting for a price increase.

Short Call – Strategy used if you think a stock’s price will fall.  However, a short call has limited profit potential in exchange for unlimited risk (if, for example, the underlying stock’s price skyrockets)

Long Put – Strategy similar to selling short stock.  However, the maximum loss is the price paid for the put, and the maximum potential profit is if the underlying stock goes to $0.

Short Put – Strategy that is the opposite of a long put.  You assume very large risk (if the underlying stock goes to $0), for a limited profit, which would be the premium you received for the put.

Next, you have the ability to buy options that are either In-The-Money (ITM), At-The-Money (ATM), and Out-Of-The-Money (OTM).

ITM – In the money options are options whose underlying stock value exceeds the strike price of the option.  These options act more like a stock, especially as they get deeper in the money.

ATM – An at the money option is the one with the greatest risk as it is at the strike price.  It is very sensitive to changes in the stock price, volatility, and time to expiration.

OTM – An out of the money option is one whose underlying stock value is below the strike price.  These options are usually the cheapest to purchase as the goal to make a profit is a large move in the underlying stock.  However, these options can expire worthless if that move never occurs.

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