Greeks, including Delta, Gamma, Theta, Vega and Rho, measure the different factors that affect the price of an option contract. They are calculated using a theoretical options pricing model (see  How much is an option worth?).

Since there are a variety of market factors that can affect the price of an option in some way, assuming all other factors remain unchanged, we can use these pricing models to calculate the Greeks and determine the impact of each factor when its value changes. For example, if we know that an option typically moves less than the underlying stock, we can use Delta to determine how much it is expected to move when the stock moves $1. If we know that an option loses value over time, we can use Theta to approximate how much value it loses each day.

Following are Greek definitions:

Delta: The hedge ratio

Delta measures how much an option’s price is expected to change per $1 change in the price of the underlying security or index. For example, a Delta of 0.40 means that the option’s price will theoretically move $0.40 for every $1 move in the price of the underlying stock or index.

Call options

• Have a positive Delta that can range from zero to 1.00.
• At-the-money options usually have a Delta near .50.
• The Delta will increase (and approach 1.00) as the option gets deeper in the money.
• The Delta of in-the-money call options will get closer to 1.00 as expiration approaches.
• The Delta of out-of-the-money call options will get closer to zero as expiration approaches.

Put options

• Have a negative Delta that can range from zero to -1.00.
• At-the-money options usually have a Delta near -.50.
• The Delta will decrease (and approach -1.00) as the option gets deeper in the money.
• The Delta of in-the-money put options will get closer to -1.00 as expiration approaches.
• The Delta of out-of-the-money put options will get closer to zero as expiration approaches.

You also might think of Delta, as the percent chance (or probability) that a given option will expire in the money.

• For example, a Delta of 0.40 means the option has about a 40% chance of being in the money at expiration. This doesn’t mean your trade will be profitable. That of course, depends on the price at which you bought or sold the option.

You also might think of Delta, as the number of shares of the underlying stock, the option behaves like.

• A Delta of 0.40 also means that given a $1 move in the underlying stock, the option will likely gain or lose about the same amount of money as 40 shares of the stock.

Gamma: the rate of change of Delta

Gamma measures the rate of change in an option’s Delta per $1 change in the price of the underlying stock. Since a Delta is only good for a given moment in time, Gamma tells you how much the option’s Delta should change as the price of the underlying stock or index increases or decreases. If you remember high school physics class, you can think of Delta as speed and Gamma as acceleration.

The relationship between Delta and Gamma:

• Delta is only accurate at a certain price and time. In the Delta example above, once the stock has moved $1 and the option has subsequently moved $.40, the Delta is no longer 0.40.
• As we stated, this $1 move would cause a call option to be deeper in the money, and therefore the Delta will move closer to 1.00. Let’s assume the Delta is now 0.55.
• This change in Delta from 0.40 to 0.55 is 0.15—this is the option’s Gamma.
• Because Delta can’t exceed 1.00, Gamma decreases as an option gets further in the money and Delta approaches 1.00.

Theta: time decay

Theta measures the change in the price of an option for a one-day decrease in its time to expiration.  Simply put, Theta tells you how much the price of an option should decrease as the option nears expiration.

• Since options lose value as expiration approaches, Theta estimates how much value the option will lose, each day, if all other factors remain the same.
• Because time-value erosion is not linear, Theta of at-the-money (ATM), just slightly out-of-the-money and in-the-money (ITM) options generally increases as expiration approaches, while Theta of far out-of-the-money (OOTM) options generally decreases as expiration approaches.

Vega: sensitivity to volatility

Vega measures the rate of change in an option’s price per 1% change in the  implied volatility of the underlying stock. While Vega is not a real Greek letter, it is intended to tell you how much an option’s price should move when the volatility of the underlying security or index increases or decreases.

More about Vega:

• Vega measures how the implied volatility of a stock affects the price of the options on that stock.
• Volatility is one of the most important factors affecting the value of options.
• Neglecting Vega can cause you to “overpay” when buying options.  All other factors being equal, when determining strategy, consider buying options when Vega is below “normal” levels and selling options when Vega is above “normal” levels. One way to determine this is to compare the historical volatility to the implied volatility. Chart studies for both of these values exist within StreetSmart Edge®.
• A drop in Vega will typically cause both calls and puts to lose value.
• An increase in Vega will typically cause both calls and puts to gain value.

Rho: sensitivity to interest rates

Rho measures the expected change in an option’s price per 1% change in interest rates. It tells you how much the price of an option should rise or fall if the “risk-free” (U.S. Treasury-bill)* interest rate increases or decreases.

More about Rho:

• As interest rates increase, the value of call options will generally increase.
• As interest rates increase, the value of put options will usually decrease.
• For these reasons, call options have positive Rho and put options have negative Rho.
• Rho is generally not a huge factor in the price of an option, but should be considered if prevailing interest rates are expected to change, such as just before a Federal Open Market Committee (FOMC) meeting.
• Long-Term Equity AnticiPation Securities® (LEAPS®) options are far more sensitive to changes in interest rates than are shorter-term options.

You can see the effects of Rho by considering a hypothetical stock that’s trading exactly at its strike price.

• If the stock is trading at $25, the 25 calls and the 25 puts would both be exactly at the money.
• You might see the calls trading at a price of $0.60, while the puts may trade at a price of $0.50.
• When interest rates are low, the difference will be relatively small.
• As interest rates increase, this difference between puts and calls whose strikes are equidistant from the underlying stock will get wider.

What can option Greeks do for you?

Armed with Greeks, an options trader can make more informed decisions about which options to trade, and when to trade them. Consider some of the things Greeks may help you do:

• Gauge the likelihood that an option you’re considering will expire in the money (Delta).
• Estimate how much the Delta will change when the stock price changes (Gamma).
• Get a feel for how much value your option might lose each day as it approaches expiration (Theta).
• Understand how sensitive an option might be to large price swings in the underlying stock (Vega).
• Simulate the effect of interest rate changes on an option (Rho).

Implied volatility: like a Greek

Though not actually a Greek, implied volatility is closely related. The implied volatility of an option is the theoretical volatility based on the option’s quoted price. The implied volatility of a stock is an estimate of how its price may change going forward. In other words, implied volatility is the estimated volatility of a stock that is implied by the prices of the options on that stock. Key points to remember:

• Implied volatility is derived using a theoretical pricing model and solving for volatility.
• Since volatility is the only component of the pricing model that is estimated (based on historical volatility), it’s possible to calculate the current volatility estimate the options market maker is using.
• Higher-than-normal implied volatilities are usually more favorable for options sellers, while lower-than-normal implied volatilities are more favorable for option buyers because volatility often reverts back to its mean over time.
• To an options trader, solving for implied volatility is generally more useful than calculating the theoretical price, since it’s difficult for most traders to estimate future volatility.
• Implied volatility is usually not consistent for all options of a particular security or index and will generally be lowest for at-the-money and near-the-money options.

Since it’s difficult on your own to estimate how volatile a stock really is, you can watch the implied volatility to know what volatility assumption the market makers are using in determining their quoted bid and ask prices.

(Source: Original article from Schwab was repurposed for this Blog post)

More than $2 trillion in foreign profits were held by U.S. corporations abroad in 2013, says Reuters.

U.S. corporations do not pay income tax on their overseas profits (something known as income tax deferral) unless they bring those profits back into the United States.

• Between 2008 and 2013, the amount of profits held overseas by American corporations almost doubled.
• General Electric alone had $110 billion overseas, followed by Microsoft (at $76.4 billion), Pfizer (at $69 billion) and Merck (at $57.1 billion).

This corporate tax issue has been at the center of congressional debate on tax reform. Some lawmakers have advocated getting rid of offshore deferral, and others have pushed for a “tax holiday” that would allow these corporations to bring foreign profits back into the United States at a low tax rate. Democratic Senator Max Baucus, former finance committee chairman, had made a number of tax reform proposals before leaving to become ambassador to China. Senator Ron Wyden has taken over Baucus’ post.

Analysts do not anticipate any real reform action until after the mid-term elections in November, but Americans can expect to see a push for a tax code overhaul in 2015.

Source: Kevin Drawbaugh and Patrick Temple-West, “Untaxed U.S. Corporate Profits Held Overseas Top $2.1 Trillion: Study,” Reuters, April 8, 2014.

Every time the equity markets hit a new high, doubts begin to arise if the markets are getting too toppy/frothy. It is usually a good time to take a step back and put things in perspective. A good comparison is usually done by going back in time to when the markets peaked in March 2000. In that light, David Kostin, chief U.S. equity strategist at Goldman Sachs, looked at some data going back to March 2000 when the technology bubble peaked and subsequenty burst. I was really close to this time period, having moved to Silicon Valley to join a team doing late stage, pre-IPO, tech venture investing.

“Veteran investors will recall the S&P  500 and the tech-heavy Nasdaq peaked in March 2000.  The indices eventually fell by 50% and 75%, respectively. It took the S&P 500 seven years to recover and establish a new high, but the  Nasdaq still remains 25% below its all-time peak reached 14 years ago.”

However, according to Kostin, there are six ways in which the two episodes differ:

Recent returns are less dramatic. Although the trailing 12-month returns are similar (22% today versus 18% in 2000), the trailing 3-year and 5-year returns are much lower (51% vs. 107% and 161% vs. 227%, respectively).

Valuation is not nearly as stretched. S&P 500 currently trades at a forward P/E of 16x compared with 25x at the peak in 2000. The price/book ratio is 2.7x versus 6.Xx. The EV/sales is currently 1.8x compared with 2.7x in 2000.

More balanced market. The reason it is called the “Tech Bubble” is that 14% of the earnings of the S&P 500 came from Tech in 2000 but it accounted for 33% of the equity cap of the index. Today Tech contributes 19% of both earnings and market cap. Top five stocks in 2000 were 18% vs. 11% today.

Earnings growth expectations are far less aggressive. Bottom-up 2014 consensus EPS growth currently equals 9%, close to our top-down forecast of 8%. In 2000, consensus expected EPS growth equaled 17%.

Interest rates are dramatically lower. 3-month Treasury yields were 5.9% in 2000 vs. 0.05% today while ten-year yields were 6.0% vs. 2.7% today. The yield curve was inverted by 47 bp. Today the slope equals +229 bp.

Less new issuance. During 1Q 2000, 115 IPOs were completed for proceeds of $18 billion. In 1Q 2014, 63 completed deals raised $11 billion.

Kostin says based on historical patterns, momentum stocks are unlikely to rebound, but the broader market should still be set for modest returns going forward.

(Sources: Goldman Sachs, Business Insider)