Option Trading Greeks

Option Greeks

If you're an options trader, you may have heard about “Greeks,” but perhaps you don’t know exactly what they are or, more importantly, what they can do for you. Read on, and we will explain what these Greek letters mean and how they can help you to better understand and evaluate the price of an option.

An option's price can be influenced by a number of factors that can either help or hurt traders depending on the type of positions they have taken. Successful traders understand the factors that influence options pricing, which include the so-called "Greeks"—a set of risk measures so named after the Greek letters that denote them, which indicate how sensitive an option is to time-value decay, changes in implied volatility, and movements in the price its underlying security.

Before you read the strategies, it’s a good idea to get to know these characters because they’ll affect the price of every option you trade. Keep in mind as you’re getting acquainted, the examples we use are “ideal world” examples.

Details of Greek

Delta

Gamma

Theta

Vega

Rho

Delta

The first Greek is Delta, which measures how much an option's price is expected to change per 1 change in the price of the underlying security or index. Or Delta is the amount an option price is expected to move based on a 1 change in the underlying stock.

It’s important to have realistic expectations about the price behavior of the options you trade. So the real question is, how much will the price of an option move if the stock moves 1? That’s where “delta” comes in.

For example, a Delta of 0.40 means that the option’s price will theoretically move 0.40 for every 1 move in the price of the underlying stock or index.

You can think of Delta, as the probability that a given option will expire in the money. For example, a Delta of 0.40 means the option has about a 40% chance of being in the money at expiration. This doesn’t mean your trade will be profitable. That of course, depends on the price at which you bought or sold the option.

You also might think of Delta, as the number of shares of the underlying stock, the option behaves like. A Delta of 0.40 also means that given a 1 moves in the underlying stock, the option will likely gain or lose about the same amount of money as 40 shares of the stock.

Delta - Call options

• Have a positive Delta that can range from 0.0 to 1.00.
• At-the-money options usually have a Delta near 0.50.
• The Delta will increase (and approach 1.00) as the option gets deeper in the money.
• The Delta of in-the-money call options will get closer to 1.00 as expiration  approaches.
•   The Delta of out-of-the-money call options will get closer to 0.0 as expiration approaches.

 

Delta - Put options

• Have a negative Delta that can range from 0.0 to -1.00.
• At-the-money options usually have a Delta near -0.50.
• The Delta will decrease (and approach -1.00) as the option gets deeper in the money.
• The Delta of in-the-money put options will get closer to -1.00 as expiration approaches.
• The Delta of out-of-the-money put options will get closer to 0.0 as expiration approaches.

 

Delta and Directional Risk

Delta is also used when determining directional risk. Positive deltas are long (buy) market assumptions, negative deltas are short (sell) market assumptions, and neutral deltas are neutral market assumptions.

When you buy a call option, you want a positive delta since the price will increase along 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 is further evaluated by gamma, which is a measure of delta's rate of change.
• Delta can also change in reaction to implied volatility changes.

Gamma

Gamma measures the rate of changes in delta over time. Since delta values are constantly changing with the underlying asset's price, gamma is used to measure the rate of change and provide traders with an idea of what to expect in the future. Gamma values are highest for at-the-money options and lowest for those deep in- or out-of-the-money.

Gamma is the rate that delta will change based on a 1 change in the stock price. So if delta is the “speed” at which option prices change, you can think of gamma as the “acceleration.” Options with the highest gamma are the most responsive to changes in the price of the underlying stock.

For example, 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 a bad thing for most traders looking for predictable opportunities.

An option with a high gamma and a 0.75 delta may have less of a chance of expiring in-the-money than a low gamma option with the same delta.

Delta can’t exceed 1.00, Gamma decreases as an option gets further in the money and Delta approaches 1.00.

Theta or Time Decay

Theta measures the change in the price of an option for a one-day decrease in its time to expiration. Simply put, Theta tells you how much the price of an option should decrease as the option nears expiration.

Since options lose value as expiration approaches, Theta estimates how much value the option will lose, each day, if all other factors remain the same.

Because time-value erosion is not linear, Theta of at-the-money (ATM), just slightly out-of-the-money and in-the-money (ITM) options generally increases as expiration approaches, while Theta of far out-of-the-money (OOTM) options generally decreases as expiration approaches.

Theta is always negative for a single option since time moves in the same direction. As soon as an option is purchased by a trader, the clock starts ticking, and the value of the option immediately begins to diminish until it expires, worthless, at the predefined expiration date.

Theta is good for sellers and bad for buyers. A good way to visualize it is to imagine an hourglass in which one side is the buyer, and the other is the seller. The buyer must decide whether to exercise the option before time runs out. But in the meantime, the value is flowing from the buyer's side to the seller's side of the hourglass. The movement may not be extremely rapid, but it's a continuous loss of value for the buyer.

Theta values are always negative for long options and will always have a zero time value at expiration since time only moves in one direction, and time runs out when an option expires.

In the options market, the passage of time is similar to the effect of the hot summer sun on a block of ice. Each moment that passes causes some of the option’s time value to “melt away.” Furthermore, not only does the time value melt away, it does so at an accelerated rate as expiration approaches.

Some additional points about theta to consider when trading:

• Theta can be high for out-of-the-money options if they carry a lot of implied volatility.
• 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.
• 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 at the same time.

Vega or Volatility

You can think of vega as the Greek who’s a little shaky and over-caffeinated. Vega is the amount call and put prices will change, in theory, for a corresponding one-point change in implied volatility. Vega does not have any effect on the intrinsic value of options; it only affects the “time value” of an option’s price.

Vega measures the risk of changes in implied volatility or the forward-looking expected volatility of the underlying asset price. While delta measures actual price changes, vega is focused on changes in expectations for future volatility.

Similarly, when volatility increases, the stock/index price starts swinging heavily. To put this in perspective, imagine a stock is trading at Rs.100, with increase in volatility, the stock can start moving anywhere between 90 and 110. So when the stock hits 90, all PUT option writers start sweating as the Put options now stand a good chance of expiring in the money. Similarly, when the stock hits 110, all CALL option writers would start panicking as all the Call options now stand a good chance of expiring in the money.

Higher volatility makes options more expensive since there’s a greater likelihood of hitting the strike price at some point.

Vega tells us approximately how much an option price will increase or decrease given an increase or decrease in the level of implied volatility. Option sellers benefit from a fall in implied volatility, but it is just the reverse for option buyers. It’s important to remember that implied volatility reflects price action in the options market. 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.

Additional points to keep in mind regarding vega

• Vega can increase or decrease without price changes of the underlying asset, due to changes in implied volatility.
• Vega can increase in reaction to quick moves in the underlying asset.
• Vega falls as the option gets closer to expiration.

Rho

If you’re a more advanced option trader, you might have noticed we’re missing a Greek — rho. That’s the amount an option value will change in theory based on a one percentage-point change in interest rates.

Rho is a measure of an option’s sensitivity to changes in the risk free interest rate.It is expressed as the amount of money an option will lose or gain with a 1% change in interest rates.

Long calls and short puts have positive rho, that is, the option price will increase with an increase in interest rates and it will decrease with a decrease in interest rates. Short calls and long puts have negative rho, that is, the option price will increase with a decrease in interest rates and it will decrease with a increase in interest rates.