Delta is the option trader's directional risk. It is the sensitivity of an option to a change in the underlying price of the commodity. It is represented, by an absolute number between 0 and 100 with the higher the number, the greater the directional risk. ITM options will have higher deltas than OTM options, while ATM options will have a delta of approximately 50, which implies that prices have a 50/50 chance of going up or down. It can also be looked at as a probability factor with a 0 delta representing no chance of finishing in the money and a 100 delta representing a 100 percent chance it will end in the money. The buyer of a call will have a positive delta; the buyer of a put will have a negative delta. Deltas are not static and shift as the underlying market moves. See gamma.

 

Vega is the option traders implied volatility risk. It is the sensitivity of an option to a change in implied volatility. As markets move at various rates of speed, option markets will price options accordingly. If a market moves slowly, options will be priced low and if the market moves fast options will be priced high. An owner of a call or a put, for example, will be positively affected by a higher implied volatility while the seller is adversely affected. Large shifts in implied volatility may cause options to rise or fall despite movement in the underlying market.

 

Theta is the option trader's time decay risk. It is the sensitivity of an option to the passage of time. All options have a specified life span and with each passing day the option erodes in value. Options, however, do not erode evenly with the majority of the time decay occurring as that option approaches expiration. The owner of options will be adversely affected by time and the option seller will benefit from the passage of time. The clock is always ticking.

 

Gamma is the option trader's change in delta risk. It is the sensitivity of an option to a change in delta. As mentioned above deltas are not static. Changes in underlying price, implied volatility and time can all affect the delta of an option. The owner of an option will have positive gamma and the seller will have negative gamma. Positive gamma positions will have proportionally the same negative theta (time decay) positions. It is often described as the curvature of the market, in that a positive gamma position will gain favorable deltas, becoming longer as the market rises and shorter as the market falls, whereas a negative gamma position will become shorter as a market rises and longer as the market falls.

 

It is the sensitivity of an option value to changes in interest rates. Except for very long term options or options that are deep in the money, normal interest rate movement has little affect on option prices.

 

 

Is the option trader's expiration risk when short an ATM option. Since only the owner (buyer) of an option can exercise their right to be long or short an underlying position the short is at their mercy. So, when the underlying market settles at or near (the owner has a right to exercise any option) a strike the short will not know until the next trading session whether they have a position in the underlying market. This can be avoided by simply buying in the short option as expiration approaches at whatever the prevailing market price.

 

Is the option trader's risk to the speed of underlying price movement. This is separate from vega (or implied volatility) in that it is solely associated with price movement of the underlying market. In an option transaction, the premium paid implies how fast the option market anticipates the market will move. The ultimate failure or success of an option position that is kept through expiration is decided by how far and fast the market eventually moves. The buyer of an option wants the underlying market to move faster than implied while the option seller wants it to move slower than anticipated.

 

Is the option trader's entry and exit risk. The ability to freely move in and out of markets is a very real risk. Option markets that provide easy access in and out of positions at reasonable bid and ask prices are imperative to risk analysis.

These are the main risk factors in options trading, but certainly not all. The ability to understand these risks is paramount to a successful trading plan.