In Part One of Learn The Fundamentals Of Options Trading, we introduced the concept of the Greeks as trading tools and discussed delta and theta.
In this second lesson on the fundamentals of options trading, we'll continue where part one left off by examining gamma and vega and discover additional distinctions on option pricing that will explain why prices move the way they do. (Note: unlike the others, vega is NOT a Greek letter.)
After delta and theta, next in line is gamma. Here again the mathematics is slightly advanced, but the idea is simple. (For those who remember some college calculus, gamma is a function of the first derivative of delta.)
Last, we look at vega. Vega measures the sensitivity of the price of an option to changes in volatility. Volatility is the frequency with and degree to which a price changes. When prices rise or fall sharply, volatility is high.
The calculations are complex, but again the idea is simple. Risk increases as volatility rises, because risk is all about uncertainty and potential loss or gain.
All are based on various models of how options prices and the assets underlying these derivatives may behave in the future. Those models are, as their proponents will agree, not exact predictions.
The two most common are perhaps the Blacks-Scholes model and the Binomial model. There's no need here to display these elegant but intimidating formulae.
The savvy trader need only remember that the data should be used as part of an overall strategy of research, not as a substitute for research.
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