Understanding Some Technical Trading Terms

You may have no idea why I'm talking about Greek stuff. If not, you're in the right place. If you do, you're still in the right place.

I'm a big fan of Greek--great food, funky alphabet, really smart and cheeky philosophers--there's really very little I've come across that I didn't like. And more than likely, before too long, then country's sagging stock market will present some awesome opportunities for profit in the markets. But that's not necessarily the purpose of this article.

What I really like about Greek is its contributions to the world of finance--specifically, stock options.

Don't get scared, I've taught you about stock options before, (here and here and here, for example, if you're interested). And I'm not about to bombard you with quantitative finance or the application of "greeks" in solving partial differential equations. We also won't be working through any option pricing models, like the one pictured here. I only have that much fun when I go on hot dates with my woman!

But seriously, before we delve into the below, please read the articles I referenced above on options basics and examples, and you'll have a better idea about what I'm about to talk about. We're about to plunge further into the rabbit hole and pummel your cerebral cortex lightly with some terminology you might find additionally helpful and indeed profitable--because that's what you're here for, right?

Understanding and Using Options Will Transform Your Wealth Journey

It's probably true that the majority of those who peruse my site regularly, maybe even you, won't ever "try this at home." And that's a shame. Why?

Because the thing is, I'm never going to sit back and lecture you about things I think you shouldn't try at home. Everything I publish is fair game, insofar as their intellect is above that of a 5th grader. I consider it all to be safe, and relatively simple. Everything I recommend is something that anyone can do, as long as they have been properly educated, and trained themselves to abide by all my investing rules. Plus, my site has a disclaimer at the bottom, so I'm safe, right?

This article outlines the basic elements of options, lovingly referred to as "the greeks." The greeks are letters that signify the components underlying and determining option prices. It's important for you to understand just the basics, and very little more.

As mentioned, option prices are determined by a set of factors--the greeks. As the greeks, or the variables making up the price, change, so does the price of an option. Just like if the price of the ingredients in a cake you bake go up, so does the overall price of the cake. Same principle.

The Greeks are used by professional traders to determine the likelihood of price and direction of trade setups, as well as to identify market anomalies which present favorable conditions for trading--let's call them "opportunities to profit."

Sound familiar? That's the same thing we look for in an investment.

The great news is, we don't use them by name in our trading strategies--but you still want to know them, because having a grasp of the concepts will allow you to identify trade setups outside of the things I recommend to you. This isn't nearly as complicated as Wall Street would have you believe.

What an Option is Made Of

Any option price is composed of mainly four components: volatility, time to expiry, stock price, and interest rates.

Volatility (Greek: Vega). First and most important in determining option pricing, Vega (AKA Volatility). It measures how much a change in volatility (price fluctuation) will affect the price of the option.

A professor of mine always said, "Options are the price of volatility." In other words, if a stock is highly volatile (if the price is moving up and down a lot), its option prices are going to be high. Why is that?

Remember, and option is a contract. A contract is high-priced if it is high-valued (worth money). It is highly-valued if it is likely to present a good profit opportunity. And, the greater the volatility, or the price movement of a stock, the greater the likelihood of profit opportunity. Make sense?

You know I mention "volatility" every once in a while here at the Village, and this is what I am referring to--the degree to which prices vary, and the magnitude of the variances.

When we are selling options, we always want vega to be high. When that is the case, we collect higher option premiums because options are more expensive. The opposite is true if we are buying.

Time (Theta). Theta is the second most important thing you need to know about option prices. Theta is known as "time decay." An option is made up of intrinsic value plus time value. If intrinsic value (also known as "moneyness") is zero, then the option is made up wholly of time value.

As expiry approaches, the time value of an option decreases, because there is less time left for the stock price to move into profitable territory, or "in(to) the money." With every passing day, the price may decline slightly. It accelerates most rapidly during the final weeks before expiry.

the amount by which the price declines daily is called Theta. As option sellers, we like theta to be high, and to sell options when time decay is the fastest and most abrupt--that means we turn a profit quicker. The best window is typically the last two weeks of an option's life.

If we deal in options, you MUST understand this component of an option's price. It can hurt you the most if you are buying options... which we rarely do.

Delta. Lastly, you should understand what delta is. The delta of an option signifies mainly, for our purposes, the probability that the option will expire in the money. An option right at the money has a delta of .5, or a 50/50 chance of being in the money. An option deep in the money has a delta close to 1.0. Conversely, an option far out of the money has a delta close to 0.

We don't talk too much about delta here. It's too technical for most readers. What I've said is enough for you to know.

Your Crash Course in Greek Is Now Complete

These are the options basics i think you need to understand to be a black belt Jedi Master of the options universe... learn them well, my young Padowan, and try using them to craft a profitable strategy. I'll regularly give options recommendations on this blog.

Live long and invest,

Jeremiah