Putting Greeks to Good Use

 | Jan 05, 2012 | 12:00 PM EST
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This commentary originally appeared Jan. 5, 2012, at 7:31 a.m. EST on Options Profits – the options trader's source for daily trading strategies and actionable trade ideas. Click here to learn more.

You can't trade options for very long without hearing about the greeks. Just as in the hard sciences, finance professionals use Greek letters to represent important variables. But instead of heat or viscosity, we're tracking variables like sensitivity to price (delta) and sensitivity to the passage of time (theta). Once you've learned what these options greeks -- these risk factors -- are, the next step is to apply them in your trading. For simplicity, let's just think about delta.

Assume that you have accumulated a series of options on SPDR S&P 500 ETF (SPY) over the past several months. You have some at-the-money calls and puts in the front month, some out-of-the-money options in the second month, a time spread further out, an iron condor expiring in June, etc. Assume also that, because of some events or new data, the bullish view you had on the markets a few weeks ago is getting tired out. Right now, you don't want to have large exposure long or short -- you don't have a strong opinion about likely market direction, so you want to be neutral with regard to price exposure. What, then, should you do with all those options in your portfolio?

Well, it depends on your existing exposure. In other words, you need to find the net delta exposure of all of your open SPY positions, including shares of the ETF. The great thing about option greeks is that they are additive: To find your net delta exposure in some asset, just add up the individual deltas of each option you hold.

In this example, let's say the sum of the deltas of all of the SPY options you have open is 500. That means you stand to make $500 if SPY rises 1 point. So, if SPY falls 2 points tomorrow, you'll lose $1,000 due to price exposure. (Your actual portfolio will also vary due to other risk factors like gamma, theta and vega.) Since you now have a neutral rather than a bullish view, you want to do something to offset that directional exposure.

Techniques for hedging deltas is a big topic for another time, but the simplest approach would be to sell short 500 SPY shares. That action would flatten out your exposure and update your portfolio to match your current view.

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