BUSINESS

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Reviewed by Khadija Khartit

Absolute vs. Comparative Advantage: An Overview

Absolute and comparative advantage are economic concepts that help companies and nations decide how to best use their resources in producing goods for trade internationally.

Absolute advantage is the ability to manufacture a product at a higher quality and a faster rate for a greater profit than competing businesses or countries. Comparative advantage considers the capability of a company or a nation to produce a product more efficiently or more cheaply than others.

Key Takeaways

• Absolute advantage is the ability to create the best possible product at the lowest possible cost among all competing producers.
• Comparative advantage considers the relative benefits of various choices of products to be produced, factoring in the lost opportunities in the discarded options.
• Both of these economic concepts are useful to businesses and nations making decisions about what products they should produce and which products they should leave to others.

Absolute Advantage

The ability of a company or nation to produce goods more efficiently than its competitors is the basis for absolute advantage. Absolute advantage can be achieved by exploiting lower labor costs, access to a supply of resources, and a large pool of available capital.

For example, Japan and Italy both produce automobiles. If Italy can manufacture higher quality sports cars and make a greater profit than the competition, Italy would have an absolute advantage in the market for sports cars. Rather than competing in that segment, Japan might devote its resources to electric cars, SUVs, or another industry niche. Rather than competing head-on with Italy’s sports car market, Japan would opt to exploit an absolute advantage in another part of the market.

Absolute advantage is accomplished by creating the good or service at a lower absolute cost per unit using fewer inputs or a more efficient process.

Comparative Advantage

Comparative advantage considers the relative benefits of various options open to a company or nation that must prioritize its output. When a country or business has multiple resources to produce various goods and services, it looks for products with a comparative advantage.

Comparative advantage takes opportunity cost into account. That is, the opportunity cost of a given option is equal to the benefits that have been forfeited in deciding against another of the options available.

For example, China might have the resources to produce either 10 million smartphones or 10 million laptop computers. If computers generate a higher profit, the opportunity cost is the difference in value lost from producing a smartphone rather than a computer.

If China earns $100 for a computer and $50 for a smartphone, then the opportunity cost is $500 million. In this example, China will probably select computers because the potential profit is higher.

Important

Opportunity cost is the benefit that would have been derived from an option other than the one chosen.

Economic Theory

Scottish economist Adam Smith helped originate the concepts of absolute and comparative advantage in his book, The Wealth of Nations. Smith argued that countries should specialize in the goods they can produce most efficiently and trade for any products they can’t produce as well.

Smith touted the marriage of specialization and international trade as they relate to absolute advantage. He suggested that England could produce more textiles per labor hour and Spain could produce more wine per labor hour, so England should export textiles and import wine, and Spain should do the opposite.

Smith’s theory assumes that the factors of production between countries don’t change, that there are no barriers to trade, and that exports and imports are equal.

British economist David Ricardo built on Smith’s concept of comparative advantage in the early 19th century. According to Ricardo, nations can benefit from trading even if one has an absolute advantage in producing everything.

Did the Economist Adam Smith Promote the Benefits of Trade?

Scottish economist Adam Smith is credited with developing the theories of absolute and creative advantage in his book, The Wealth of Nations. According to Smith, countries should focus on goods they can produce efficiently and use trade to acquire anything they can’t efficiently make themselves.

The mutual benefits of trade form the basis of Smith’s argument that specialization, based on a nation’s intrinsic strengths and resources, can lead to prosperity for all.

What Is an Example of Absolute Advantage?

Saudi Arabia has an absolute advantage in the oil industry, given the sheer size of its oil reserves. However, about 95% of the nation consists of desert, so it is unlikely to compete effectively as an agricultural producer. Saudi Arabia imports about 80% of its food while paying for it with the money it receives from oil exports.

What Is the Benefit of Having Absolute Advantage in One Product?

Making a product that others need and can’t produce allows a company or country to maintain a trade relationship for goods and services it needs but can’t produce. This creates a mutually beneficial trading relationship.

The Bottom Line

Scottish economist Adam Smith explained how countries can thrive by making only the goods they can produce most efficiently for export while importing the products they can’t make efficiently. This is the concept of absolute advantage, which can be used by companies and nations to decide what products they should produce.

The concept of comparative advantage is a somewhat different take on the issue. It suggests that, with various options available, a nation or company should choose the one with the highest potential benefit, while factoring in the lost opportunity of the options that were discarded.

Reviewed by Somer Anderson
Fact checked by Vikki Velasquez

What Are Option ‘Greeks?’

When investors want to profit from a stock’s price movements while risking less money than buying shares outright, they often turn to options. By using options, traders can profit whether stock prices go up, down, or sideways. Options can even work as insurance against losses in other investments.

But unlike stocks, whose prices go up or down based on supply or demand, options have several internal factors affecting their price: Time is constantly eroding their value—and the clock itself moves faster. Market volatility can abruptly raise or lower their price. And, changes in the price of the underlying stock can cause dramatic swings in an option’s worth.

To help measure and manage these various risks, traders rely on mathematical gauges called the Greeks. Named after the Greek letters delta, gamma, theta, and vega, these act like dashboard warning lights, helping traders understand how different market conditions affect their options positions.

Key Takeaways

• Delta shows how much an option’s price will change relative to a $1 move in the underlying stock, ranging from -1.0 to +1.0.
• Gamma measures how quickly delta changes as the underlying stock price moves, helping traders understand the risks in rapid price swings.
• Theta calculates how much value an option loses each day as it approaches expiration, with the change accelerating as the expiry date approaches.
• Vega indicates how sensitive an option’s price is to changes in expected market volatility, with longer-dated options generally being more sensitive.

Understanding Options Contracts

Investors use options contracts for one of two purposes: They are protecting their other investments, an activity called hedging. Or, they are attempting to profit from an asset’s price moves without buying the asset. That’s called speculating.

An option gives you certain rights but not obligations. It’s like putting down a deposit on a house. You’re agreeing to buy that house at a set price within a specific time, but you can walk away if you change your mind (at a cost).

There are two basic types of options:

• A call option gives you the right to buy an asset at a specific price.
• A put option gives you the right to sell an asset at a specific price.

Each options contract has specific terms:

• Strike price: The price at which you can buy or sell the asset.
• Expiration date: The deadline by which you must use the option.
• Premium: The upfront payment for the contract.

The price or value of an option (its premium) changes constantly based on complex mathematical models. The most widely used is the Black-Scholes model, which accounts for the underlying asset’s price moves, time until expiration, and market volatility. You don’t have to calculate this yourself—most trading platforms do it for you.

How Options Make or Lose Money

Options traders who are considering a position’s profitability—whether they have intrinsic value—use specific terms that compare the option’s strike price with the underlying asset’s market price.

The three key positions are as follows:

• At-the-money (ATM): The option’s strike price equals the current market price of the underlying asset. This is breaking even.
• In-the-money: Given the current market value, there is an immediate profit in exercising the option. For call options, this means the market price is above the strike price. For puts, it’s the opposite—the market price is below the strike price.
• Out-of-the-money: Exercising the option would result in a loss. For calls, this means the market price is below the strike price. Nobody would pay more through the option when it could be bought for less in the market. For puts, it means the market price is above the strike price.

Important

Remember, if you’re buying options, you’re going long. If you’re selling options without owning the underlying asset (called naked selling), you’re in the short position.

What Affects an Option’s Price

Stocks move up or down mostly based on company performance and market conditions. Options respond to several factors simultaneously:

Underlying Asset’s Price

The most direct influence is movement in the underlying stock or asset. When a stock’s price rises, call options generally become more valuable while put options typically lose value. The opposite occurs when stock prices fall.

Time Decay

Like a melting ice cube, options lose value as they approach their expiration date. This process of time decay accelerates in the final weeks before expiration, particularly for at-the-money options. This erosion is inevitable and affects all options.

Market Volatility

Just as home insurance costs more in hurricane-prone areas, options become more expensive when markets are volatile or are expected to be.

Implied volatility is the market’s view of the likelihood that an asset’s price will change. Thus, higher volatility means higher option prices, regardless of whether you’re buying calls or puts.

Interest Rates

While usually less significant than other factors, interest rates affect options pricing. Higher rates typically make call options more expensive and put options cheaper, though this effect is most noticeable in longer-term options.

Note

Greeks are usually viewed with an option price model to help understand and gauge associated risks.

How These Elements Interact

Let’s examine how these factors typically affect both call and put options:

But the story gets more interesting when we look at positions traders might take. Here’s how these factors affect different positions:

If a trader is long on a call option, a rise in implied volatility is favorable. That’s because higher volatility is typically priced into the option premium. Meanwhile, if a trader establishes a short call option position, a rise in implied volatility will have a negative effect.

For example, if you buy (go long on) a call option, you benefit from the following:

• Rising stock prices
• Increasing market volatility
• Having more time until expiration

However, you’re hurt by the following:

• Falling stock prices
• The constant tick of time decay

The opposite is true if you sell (go short) that same call option. As an options seller, time decay works in your favor, but you’re hurt by rising volatility.

The complexity of these factors is why experienced options traders rely on specific measures called the Greeks to understand their risk exposure. These measurements help traders quantify and manage how these factors affect their positions.

The Greeks

Below are the four primary risk measures—the Greeks—that traders often consider before opening an option position.

Delta	Gamma	Theta	Vega
Measures impact of a change in the price of underlying asset	Measures the rate of change of delta	Measures impact of a change in time remaining	Measures impact of a change in volatility

Delta

Delta is often said to be the most important of the Greeks. It measures the change in an option’s price from a change in the underlying security.

• For call options, delta ranges from 0 to +1.00
• For put options, delta ranges from 0 to -1.00
• A delta of 0.50 means the option price will move about 50 cents for every $1 change in the stock price

For example, if you own a call option with a delta of 0.40 and the stock price increases by $1, your option should gain about 40 cents in value (provided the other Greeks remain the same).

The opposite happens if the stock falls—you’d lose about 40 cents.

Delta as an Indicator of Probability

Many traders also use delta as a rough gauge of the probability that an option will be profitable at expiration:

• A call option with a 0.30 delta suggests about a 30% chance of being profitable at expiration.
• A call option with a 0.70 delta suggests about a 70% chance of being profitable at expiration.
• At-the-money options typically have deltas around 0.50, suggesting a 50/50 chance.

This generally means traders can use delta to measure the directional risk of a given option or options strategy.

Higher deltas may be suitable for higher-risk, higher-reward strategies that are more speculative, while lower deltas may be ideally suited for lower-risk strategies with high win rates.

Example of Delta

Suppose one OTM option has a delta of 0.25, and another ITM option has a delta of 0.80. A $1 increase in the price of the underlying asset will lead to a $0.25 increase in the first option and a $0.80 increase in the second option.

Traders looking for the greatest traction might consider high-delta options, although these options tend to be more expensive since they’re more likely to expire ITM.

An at-the-money option, meaning the option’s strike price and the underlying asset’s price are equal, has a delta value of about 50 (0.5 without the decimal shift). That means the premium will rise or fall by half a point with a one-point move up or down in the underlying security.

Delta and Directional Risk

When you buy a call option, you want a positive delta since the price will increase with the underlying asset price. When you buy a put option, you want a negative delta where the price will decrease if the underlying asset price increases.

Three things to keep in mind with delta:

• Delta tends to increase closer to expiration for near or at-the-money options.
• Delta can also be assessed with gamma, a measure of delta’s rate of change.
• Delta also reacts to changes in implied volatility.

New traders often chase high delta options for bigger moves, but a higher delta means a higher cost and risk.

Using Delta in Trading

Traders use delta in several ways:

1. To estimate position risk
2. To gauge the likelihood of profit
3. To choose options based on risk tolerance

Gamma

Gamma tells you how quickly delta will change when the stock price moves. Gamma values are highest for at-the-money options and lowest for those deep ITM or OTM.

Suppose that two options have the same delta value, but one option has a high gamma, and one has a low gamma. The option with the higher gamma will have a higher risk since an unfavorable move in the underlying asset will have an oversized impact.

High gamma values mean that the option tends to experience volatile swings, which is bad for traders looking for predictable prospects.

How Gamma Works

• Gamma is always positive for long options (whether calls or puts)
• Gamma is always negative for short options
• Gamma is highest for at-the-money options
• Gamma approaches zero for deep ITM or OTM options

Example

Let’s say you own a call option with the following details:

• Delta: 0.50
• Gamma: 0.05

If the stock rises $1, then the following occurs:

• Delta will increase by about 0.05 to 0.55
• Your option will gain about 50 cents from the initial move
• Future moves will have a slightly bigger impact because of the higher delta

Thus, an option with a high gamma and a 0.75 delta may have less chance of expiring ITM than a low gamma option with the same delta.

The table below shows how much delta changes following a one-point move in the underlying asset’s price. When call options are deep OTM, they generally have a small delta because changes in the underlying generate tiny changes in pricing. However, the delta becomes larger as the call option gets closer to the money.

Example of Delta After a One-Point Move in the Price of the Underlying Asset
Strike Price	925	926	927	928	929	930	931	932	933	934
P/L	425	300	175	50	-75	-200	-325	-475	-600	-750
Delta	-48.36	-49.16	-49.96	-50.76	-51.55	-52.34	-53.13	-53.92	-54.70	-55.49
Gamma	-0.80	-0.80	-0.80	-0.80	-0.79	-0.79	-0.79	-0.79	-0.78	-0.78
Theta	45.01	45.11	45.20	45.28	45.35	45.40	45.44	45.47	45.48	45.48
Vega	-96.30	-96.49	-96.65	-96.78	-96.87	-96.94	-96.98	-96.99	-96.96	-96.91

The column showing profit/loss (P/L) of -200 represents the at-the-money strike of 930, and each column represents a one-point change in the underlying asset.

The at-the-money gamma is -0.79, which means that for every one-point move in the underlying, the delta will increase by exactly 0.79. (For both delta and gamma, the decimal has been shifted by two digits by multiplying by 100.)

A high gamma can be both friend and enemy:

• Friend: When the stock moves in your favor, a high gamma means your profits accelerate.
• Enemy: When the stock moves against you, a high gamma means your losses accelerate.

Using Gamma in Trading

Traders review gamma when they are doing the following:

• Deciding whether to trade near-term vs. longer-term options
• Evaluating risk in option spreads
• Managing positions during volatile market periods

Theta

Theta measures the rate of time decay in the value of an option or its premium. Here are some of the main points about theta:

• As time passes, the chance of an option being profitable or ITM decreases.
• Time decay tends to accelerate as the expiration date draws closer.
• Theta is always negative since time moves in the same direction.
• Theta is generally good for sellers and bad for buyers.

Example of Theta

An option premium with no intrinsic value will decline at an increasing rate as expiration nears.

The table below shows theta values at different time intervals for an S&P 500 Dec at-the-money call option. The strike price is 930.

As you can see, theta increases as the expiration date gets closer (T+25 is expiration). At T+19 (six days before expiration), theta has reached 93.3, which tells us that the option is now losing $93.30 per day, up from $45.40 per day at T+0 when the hypothetical trader opened the position.

Table 6: Example of Theta values for short S&P Dec 930 call option
	T+0	T+6	T+13	T+19
Theta	45.4	51.85	65.2	93.3

Theta values appear smooth and linear over the long term, but the slopes become much steeper for at-the-money options as the expiration date grows near. The extrinsic value or time value of the ITM and OTM options is very low near expiration because the likelihood of the price reaching the strike price is low.

Some additional points about theta to consider when trading:

1. Theta can be high for OTM options that have a lot of implied volatility.
2. Theta is typically highest for at-the-money options since less time is needed to earn a profit with a price move in the underlying.
3. Theta will increase sharply as time decay accelerates in the last few weeks before expiration and can severely undermine a long option holder’s position, especially if implied volatility declines simultaneously.

Vega

While delta measures actual price changes, vega measures the change in expectations for future volatility. Higher volatility makes options more expensive since there’s a greater likelihood of hitting the strike price at some point.

Given an increase or decrease in implied volatility, Vega tells us how much an option price will increase or decrease. Some further points to keep in mind:

• Option sellers benefit from a fall in implied volatility, but the reverse is true for option buyers.
• When option prices are bid up because there are more buyers, implied volatility will increase.
• Long option traders benefit from pricing being bid up, and short option traders benefit from prices being bid down. This is why long options have a positive vega and short options have a negative vega.
• Vega can increase or decrease without price changes of the underlying asset because of changes in implied volatility.
• Vega falls as the option gets closer to expiration.
• Traders can employ a vega-neutral position to offset the underlying asset’s implied volatility.

Minor Greeks

Options traders also look to other, more subtle risk factors. One is rho, which represents the rate of change between an option’s value and a 1% change in the interest rates. Thus, it measures an option’s sensitivity to interest rates.

Assume a call option has a rho of 0.05 and a price of $1.25. If interest rates rise by 1%, the call option’s value will increase to $1.30, all else being equal. The opposite is true for put options. Rho is the greatest for at-the-money options that have a long time until expiration.

Some other minor Greeks include lambda, epsilon, vomma, vera, speed, zomma, color, and ultima. They are increasingly used in options trading strategies as online platforms can quickly compute and account for these complex and sometimes esoteric risks.

What Are the Greeks in Options?

The Greeks are financial metrics that traders can use to measure the factors that affect the price of an options contract. The most widely used Greeks are delta, gamma, theta, and vega.

How Does Lambda Help Traders Measure Risk?

Lambda (also called elasticity) measures the percentage change in an option’s value relative to the percentage change in the underlying asset’s price. This helps traders compare options across stocks or indexes at various price levels.

For example, lambda tells you whether a $50 stock option and a $500 stock option are equally sensitive to a 1% move in their respective underlying stocks.

What Factors Affect Options Pricing?

Options pricing can be affected by several factors. These include the strike price, the price of the underlying asset, the total time until the option’s expiration date, interest rates, and volatility.

Why Do Traders Need to Understand Rho in A Rising Rate Environment?

Rho measures how sensitive an option’s price is to changes in interest rates. While considered less important than the main Greeks during stable rate periods, rho becomes consequential during times of significant rate changes.

For instance, a long-term call option with a rho of 0.05 would gain about 5 cents in value for every 1% rise in interest rates, making rho particularly relevant for LEAPS and other long-dated options during rate-hiking cycles.

Are Options Contracts Risky?

Like any leveraged investment tool, options carry risks that must be understood and managed carefully. Buying options limits your risk to the premium that is paid up-front. Selling options can expose you to significant or even unlimited losses if the market moves sharply against your position.

Options can reduce portfolio risk when used properly for hedging—such as buying put options to protect against stock market declines.

The Bottom Line

Options are risky but they become less risky if you understand and manage their complexity. Thus, understanding option Greeks is essential for anyone serious about options trading. They’re not just theoretical concepts but practical tools for measuring and managing risk.

Understanding how the Greeks work together can mean the difference between consistent profits and unexpected losses.

Successful options traders typically start by mastering the main Greeks (delta, gamma, theta, vega) before considering minor Greeks like rho and lambda for more sophisticated strategies.