The financial world is an amalgam of social and mathematical science. As a result, some of the jargon that financial experts use is derived from plain-language explanations of economic concepts, while other terms are borrowed from the mathematical theories underlying many economic principles. As the first part of this article discussed, the Greek letters alpha and beta are used to help define the risk and return characteristics of a particular asset or portfolio.
However, the use of Greek doesn't stop with its alphabet's second letter. The theories behind options pricing provide a number of additional uses for Greek letters. Although options can be complex and the math involved in pricing them fairly difficult to understand, this brief description of the terms and their uses should make you feel at least a little more comfortable.
Option basics
Options allow investors to obtain the rights to buy or sell securities at a specified price. An option that gives someone the right to buy securities is called a call option; a put option gives someone the right to sell. Because options give their owner the right but not the obligation to buy, they can never have a negative value; you can never lose more than you pay for the option. Because options are generally much less expensive than the underlying securities themselves, they provide a way for investors to use leverage to magnify the potential returns on a profitable investment. For example, if you want to buy 100 shares of 3M
The Motley Fool's FAQ on options gives more helpful information on understanding options. In general, individual investors who dabble in options can find themselves outclassed by professionals who make their living trading options, so you should tread warily if you decide to become a novice options investor.
Options and Greek letters
Even if you never buy a single option in your entire life, you'll be indirectly affected by the actions of professional options traders. Professionals often use options to hedge against stock positions they own. In order to produce the correct hedge, you have to know how the price of the options you buy or sell will move as the price of your stock changes. In simplest terms, the price of an option depends largely on four things: the price of the underlying stock, the amount of time left until the option expires, the volatility of the underlying stock's price, and the prevailing risk-free interest rate.
This is where Greek letters enter the picture. Delta refers to how much the price of an option will move in relation to a change in price of the underlying stock. So for instance, if an option has a delta of 0.5, then an increase in the stock price of $1 will make the value of the option change by $0.50 -- either up or down, depending on the type of option. As a result, if you wanted a completely neutral hedged position, you'd need options on twice as many shares as you own.
The value of delta, however, isn't constant; it also changes with the price of the underlying stock. Another value, gamma, measures how the delta value will change with the stock price. Because delta constantly changes, you have to keep adjusting your hedging strategy if you want the behavior of your overall portfolio to remain neutral. The higher the gamma value, the faster the delta value will change with the stock price, and the more you'll have to adjust your hedge.
In addition, the other three primary determinants of option price have similar values represented by Greek letters. The theta value refers to how the price of an option falls with time. Similarly, the sensitivity of an option's price to changes in interest rates of fixed-income securities without default risk, such as Treasury bills, is represented by the letter rho. Although there were still plenty of letters available, options experts went beyond the Greek alphabet to choose the pseudo-Greek-sounding word vega to represent the value that measures sensitivity to changes in the price volatility of the underlying stock.
Although you may never need to understand the mathematics behind option prices, you may encounter some of these Greek letters on more familiar ground. For instance, delta hedging practices are sometimes cited as contributing factors to major price movements in certain assets. If the transactions that professionals must make to keep themselves perfectly hedged are significant enough in size to move the markets, then you may see delta hedging mentioned in the financial news that day.
On the other hand, if someone who's trying to sell you something starts referring to these Greek letters, you should probably take it as a warning sign. Unfortunately, some professionals use jargon in an attempt to sound like an expert and to convince their audience that they know what they're talking about. Even if they do in fact understand these concepts, it's essential that they be able to explain things to you in more simple terms. Without that ability to communicate clearly, you'll likely find that you're forced to take the professional's advice on faith, which is not only uncomfortable but also leaves you open to potential mistreatment.
If you're lucky, your exposure to Greek will involve words like gyros, spanakopita, and baklava, rather than financial values represented by letters of the alphabet. Nevertheless, if you find yourself faced with these concepts, this small bit of knowledge should allow you to hold your own.
Related articles:
- It's All Greek to Me, Part 1
- Beta: The Alpha and Omega to Risk Analysis?
- Hedge Fund Wizards
- Why We Avoid Options
If you want a lot of alpha without a lot of beta, get through the Greek and take a look at Motley Fool Champion Funds. Fool fund expert Shannon Zimmerman looks far and wide for funds that will produce exceptional returns. You can see for yourself with a free 30-day trial.
Fool contributor Dan Caplinger took Latin instead of Greek, but he can still decipher a letter here and there. He doesn't own shares of 3M, which is an Inside Value pick. The Fool's disclosure policy translates in any language.
