Masters Series: How to Learn Greek in Five Minutes and Profit

Editor's note: After this one simple tip… you won't be intimidated by options-trading ever again.

 

Dr. David Eifrig has one of the most successful options-trading track records in the industry. Since launching his Retirement Trader advisory in 2010, he has closed 176 out of 178 positions for a gain. That's an incredible 98% success rate in one of the "scariest" areas of the market…

 

Many people shy away from options trading because they're afraid it's too complex. They worry about "the Greeks" – the letters professional traders use to measure the movements of options prices.

 

But in today's edition of our weekend Masters Series – excerpted from the February issue of his Retirement Trader – "Doc" says to be successful in the options market, there's only one "Greek" concept you need to know. It's easy to calculate… and chances are, you already understand it intuitively.

 

Read on to see how you can start using this simple concept immediately to improve your trading…

 

 

 

Everybody hates "The Greeks"…

 

The vast majority of individual investors – perhaps 90% of them – will never trade options. And the No. 1 excuse is it's "too complicated." They're afraid to try something new and are intimated by the perception that the math required is complex.

 

That fear is epitomized by the Greek letters professional traders use to measure how options will react to factors that influence options prices. Many folks just shut down when they hear the pros bandy about terms like "delta," "theta," "vega," and "rho" – aka "The Greeks."

 

Resist that impulse…

 

As I said, the Greeks are simply a set of statistics that measure how an option's price will react to different factors. They get their names from the Greek symbols they've been given in math formulas.

 

Full-time option experts on Wall Street's trading floors use Greeks to make all sorts of trades, using three-dimensional charts on multiple screens to find anomalies in the market. New options traders see all these complex calculations and start to think they won't be able to understand options.

 

That's simply not true. You can use the Retirement Trader strategy without them.

 

And what most options traders never take the time to discover is… there's one "Greek" that everyone understands intuitively.

 

Today, I'm going to describe this one, simple Greek. It's not complicated. With just some elementary arithmetic, you can start using it immediately to improve your trading… And you'll see right away why this particular measure has us making some major changes to our portfolio…

 

 

Remember that an option's price depends on four things: the stock's price, the time left on the option, volatility, and interest rates.

 

Beyond those basics, the four Greeks measure how an option's price reacts to changes in each of those values. For instance, the first Greek, known as delta (Δ), measures how a change in the stock price affects the price of the option. For example, if the stock moves up $1 and the option price jumps $0.50, the delta is 50%.

 

How volatility (ν) and interest rates (ρ) affect option pricing is a little harder to grasp.

 

But there's one Greek everyone can understand immediately… the passage of time.

 

Options are worth more the further they are from their expiration date. As time passes, the price of an option falls. That's called "time decay."

 

Let's look at an example. In Retirement Trader, we normally sell options. But for simplicity, we'll look at buying options to illustrate this point.

 

Buying a put is a bet that a stock will go down within a certain period. Here's an example… Say social-media service Facebook (FB) trades for about $70 a share. But say a trader thought shares were going to collapse to less than $45 in the next six months.

 

To make that bet, the trader buys a $45 (the strike price) put option for $1 (the option premium).

 

Over the course of six months, a lot could happen. The company will announce a couple earnings reports. The numbers could be bad. New social networks could get started, creating competition. Or economic growth could slow, putting pressure on its revenue streams…

 

But let's say nothing really bad happens… Imagine the next three months pass, and Facebook is still at $70.

 

The options trader still needs Facebook to drop all the way to $45. But it only has three months to do it rather than the original six. That's a lot less time for "something bad" to happen to Facebook.

 

It's much harder for a stock to move that much in three months than it would be in six. There's simply not enough time for the stock to make such a big move.

 

For that reason, the price of the option is much lower… probably as low as $0.10.

 

You can see as time passes, the price of an option declines (if all the other things like share price stay the same).

 

This "time decay" is measured by the Greek letter theta (Θ). Easy, right? "T" for time, "T" for theta. Theta is essentially the option price divided by the number of days left on the trade.

 

You may have noticed that time decay is bad for the option buyer, but time decay works to the advantage of an option seller.

 

Time decay makes an option seller money. And just how much money is a simple calculation…

 

 

The theta you may see quoted in an options-trading platform uses a formula that involves calculus. But we don't need all that.

 

Figuring out a usable version of theta is easy.

 

Let's say you want to sell an option on a hypothetical stock, ABC Company (ABC). You consider selling a $55 put that expires in two months for $1.50.

 

Remember… each option contract equals 100 shares. So as a put seller, you'll collect $150 in your account. If shares of ABC are above $55 at expiration, you get to keep the $150.

 

We're selling that put and expecting the time decay to slowly take it to zero in two months, a span of 60 days.

 

That means we expect to earn $0.025 a share per day (the $1.50 option premium divided by 60 days to expiration). If you sold one option contract, that makes for $2.50 per day.

 

That 2.5 cents per day is our "theta" when we enter the trade.

 

Over the course of two months, the price of the stock can rise or fall. You can recalculate the theta at any time to see just how much money you're earning by sitting and waiting.

For instance, the stock could quickly rise to $60 in just 10 days. If so, the option price would fall to around $0.25. You've got 50 days left in the trade, so your theta has decreased from $2.50 per day to $0.50 per day (the new $0.25 option premium divided by 50 days left to expiration).

 

At this point, you can see that it's probably more profitable to close out the trade than to keep making money from time decay.

 

Learning this simple calculation of theta should give you a better appreciation of how Retirement Trader put sellers make money – and adjust their positions – with each tick of the clock.

 

Here's to our health, wealth, and a great retirement,

 

Dr. David Eifrig Jr., MD, MBA

 

 

Editor's note: Selling put options is one of the only trading strategies in America that essentially guarantees you will generate income without buying a single stock upfront. With this strategy, you can tap into one of the most heavily traded – yet misunderstood – areas of the market… sit back… and collect hundreds of dollars on stocks you don't even own.

 

Get the details of Doc's winning strategy – and watch how it helped a novice investor collect $320 in less than five minutes – with a trial subscription to Retirement Trader.