DEFINITION of 'Charm'
Charm is the rate at which the delta of an option or warrant changes over time. Charm refers to the second order derivative of an option's value, once to time and once to price. It is also the derivative of theta, which measures the time decay of an option's value.
BREAKING DOWN 'Charm'
Charm shows how much an option changes each day until expiration. For example, an investor has an out-of-the-money call with a delta of 15% and a normalized charm of 1. As an out-of-the-money option, the odds of expiring in the money need to fall over time. Other things being equal, when the investor looks at the call the next day, he expects it to have a delta of 14%.
Importance of Charm
Charm is relevant for options traders. Because the market closes for two days each weekend, rather than overnight, the charm’s effect is magnified. For example, when the market closes Tuesday at 5 p.m. and reopens Wednesday at 8 a.m., charm has only half of a day. When the market closes Friday at 5 p.m. and reopens Monday at 8 a.m., two and a half days pass without trading the underlying security. Options traders, especially those managing delta-hedged positions, must pay close attention to their charm on Friday as it impacts their options action on Monday.
Say a trader places a delta-hedged call option on Friday with a charm of 1 and 15% delta; he is short 15 lots of the spot product for every 100 calls he owns. By Monday at 8 a.m., the call delta may have decreased to 12.5%; two and a half days have passed multiplied by the charm of 1. The trader’s delta hedge is no longer accurate; he is too short the underlying security. If the spot market opens higher on Monday, the trader has to buy back deltas to cover his position and reestablish a delta-neutral stance. Special attention is needed around a charm’s expiration time, as it may become very dynamic.
Option Positions With Greater Charm Risk
Some portfolios are self-hedging against charm risk. For example, an investor owns a 15% delta call and a -15% delta put. The charm on these options is offset, leaving them charm-neutral. Since charm makes the option delta tend toward zero over time for out-of-the-money options, the call delta falls over time and the put delta rises toward zero. The position is called a strangle because it is a long out-of-the-money call and put.