If the option Greeks seem foreign to you, you are not alone! The majority of novice options traders may not even know initially about their existence until they start trading stock options and experience “symptoms” of the Greeks. And though we are not referencing a far away, southeastern European country known as Greece directly, option Greeks are denoted by Greek letter names to which they correlate. In this article option greeks will be explained in layman’s terms.
There are major and minor Greeks in the financial world. We are going to focus on the major ones in this article that relate to an underlying asset and its sensitivity to time decay, volatility, and price movement. Only through experience and education can a trader really come to terms with the Greeks and utilize their information to their advantage.
Option Premium Influencers
Let’s first talk a little about options and what influences their premium.
Trading options can provide leverage, which makes them attractive to day traders, swing traders, and investors starting out with smaller accounts. Leverage simply means you can increase your buying power and control more shares of an underlying stock with less capital.
To buy an options contract, which represents 100 shares of a stock, you must pay a premium. The premium is the price of an option’s contract.
When narrowed down, three key factors affect the price of an option.
1) Stock Price
As the stock price increases or decreases in value, so does the value and cost of the options premium. Depending on whether you bought a call or put that is at the money, in the money, or out of the money, the premium will increase or decrease in value based on the price change of the underlying asset’s actual cost and the contract’s time of expiration.
2) Expiration Date
All options have an expiration date that represents when the contract expires. The trader has the right, but not the obligation, to buy or sell the asset for a given price by the expiration date. The goal is to profit from the price difference between when it was bought and sold before the contract expires. Time decay (how close to expiration) and the stock’s price will directly affect the value and cost of an option’s premium.
Market volatility measures the variance of returns or change in the price of an underlying stock over a given time period. If the market atmosphere of a stock is considered highly volatile, with prices bouncing up and down, it is often characterized as unpredictable due to large fluctuations in value. If volatility increases, implying the likelihood of price change, the premium for an option will likely increase as well.
It is important to understand that a stock’s price, its rate of price fluctuation, and a contract’s expiration date influence an option’s premium and bottom line, a trader’s profit or loss.
This is where the option Greeks enter. They are calculations that provide values and risk parameters based on mathematical models in relationship to stock price, market volatility, and time value decay.
Major Option Greeks
There are four, let’s recognize five, primary option Greeks. The major four are Delta, Gamma, Theta, and Vega. We are also going to briefly discuss a fifth key Greek, Rho, which doesn’t always make the primary list but has weight and importance.
Each measures sensitivity related to the premium influencers we spoke of previously and provide parameters for measuring risk. These measures are considered critical by many investors that trade the options market. They can be relied upon to implement informed decisions when opening an options trading position.
Each of the option Greeks is calculated using complex mathematical equations which a trader can learn how to calculate, however many brokers make it easy and supply the values of each of the Greeks for investors. The information will usually be available in the options chain when selecting a trade position.
Delta is the measure of change in an option’s premium resulting from a change in the underlying price of the stock.
Options cost much less than the actual stock. Some traders think the options price moves dollar for dollar relative to the stock, but this simply isn’t true. Think about it, if you paid less capital to control your stock options shares, why would you receive equal benefits as someone who owns the stock? It wouldn’t be equitable or fair.
Since the option’s value doesn’t move dollar for dollar as the stock price increases or decreases, we can rely on the delta value to tell us the percentage it will move per $1 change in stock price. It is important to note that call options will have a positive delta, while put options have a negative delta.
Example: The delta value of .45 means that if the stock price increases by a dollar, the options premium will increase by .45 (ideal scenario). If you purchased a call trade position at $1.50, and the stock goes up a $1.00, your option is now worth more at $1.95 (an increase of .45). Since an options contract is 100 shares, a .45 move is a $45 profit in this example.
Traders also use delta to gauge whether a trade will expire in the money. An option’s delta will increase as the option gets further in the money (ITM) as the likelihood it will be (ITM) at expiration increases. As an option gets further out of the money (OTM), the likelihood it will be in the money at expiration decreases, thus reducing the option’s delta.
Gamma measures the sensitivity of delta to the movement of the underlying asset’s price over time. It is the rate at which delta will change based on a one-dollar move in the underlying stock price. Traders use gamma to estimate how much delta will shift if the price of the underlying stock changes.
While delta changes based on stock price value, gamma is a constant that represents the rate of change of delta. This makes gamma useful for determining the stability of delta. This information can be used to project the probability of an option reaching the strike price at expiration.
Example: An option with a high gamma and a .70 delta may have less of a chance of expiring in the money than a low gamma option with the same delta value.
High gamma values mean that the option tends to experience volatility, or price swings. This is unfavorable for most traders looking for predictable trade opportunities. The option with the higher gamma will be of higher risk, since an unfavorable move in the stock price will have an oversized impact.
Theta measures the rate of change of the option’s price relative to the time left before expiration. Traders use theta to estimate how much value the option position might lose each day as expiration nears.
One way to remember theta is to attach it to the phrase time decay (both starting with the letter T). Time decay describes the passing of time in relation to the erosion of the option’s premium, or price.
Example: A trade position that expires in 25 days has an opening theta position of 35.5. By the time it reaches a week before the expiration date, 83.40 is the theta figure. This means that the option price is estimated to decrease by $83.40 a day.
As soon as a trader takes on an option position, the race is on! A trader has a short period of time to close out their position by taking profit, loss, or exercising their option.
As the option expiration draws near, there is less time to earn a profit from the trade. The options position has less of a chance of finishing in the money or profitable as time passes, which increases the theta calculation.
Vega measures the risk of changes in implied volatility (IV), or expected price fluctuations, of the underlying asset’s price.
Vega reacts to price swings of the stock and can increase or decrease in value without price changes. Since implied volatility reflects the price action in the options market, Vega increases in reaction to the quick price movements of an asset; it decreases as the option nears expiration.
Volatility changes premium. Higher volatility will make options contracts more expensive, since they are more likely to capture the strike price at some point.
Vega will communicate to a trader how much an option price will increase or decrease given a one-point change in volatility. Option buyers benefit from an increase in volatility, whereas option sellers benefit from a fall. Also, note that longer term options will have a higher Vega versus shorter term.
Example: An options position has a Vega of .30. If an options trader purchased that option at $1.20, Vega estimates the premium will increase or decrease in value by .30 if implied volatility moves a point. If volatility increased in this example, the value of the option would increase from $1.20 to $1.50.
Rho measures the amount the option value will adjust given a 1% change in the interest rates.
Depending on a trader’s investment style, rho’s effects may not be so pertinent. If a trader’s style is to day trade or uses shorter-term options, this Greek isn’t so much a factor. However, rho may have a more significant effect on longer-term trade positions.
Example: A call option position has a rho of 0.08 and a price of $1.30. If interest rates rise by 1%, the value of the call option will increase to $1.38, all else being equal. The opposite would be true for put options.
Summary: Option Greeks Explained
There are major and minor option Greeks. The majors, Delta, Gamma, Theta, Vega, and Rho, are the most used Greeks in options trading.
They are informative tools that can provide risk parameters that options traders can add to their trading strategies.
Even though they each may seem foreign and complex, a trader can use them to their advantage when they recognize what each option Greek measures!
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