Option Greeks may be difficult for a novice investor to use. To understand advanced stock options concepts, you should first attempt to learn all of the fundamentals of stock options. You’ll need to also make sure you are familiar with the benefits and risks that accompany options and how they are traded and quoted. Many people who are options traders may have heard about Option Greeks, but don’t have a clue as to what they are. In this post, we will attempt to explain to you what they are and how they can benefit you as you try to evaluate the price of an option.
Who are the Greeks and What Can They Do for You?
Option Greeks help options traders make better decisions about which ones to trade and when they should trade them. Here’s how they can help you:
- Delta = Measures the change of an option’s price stemming from a change in the underlying security.
- Gamma = Approximate how much the Delta will change when the stock prices change. (Gamma is based on Delta.)
- Theta = Give you a better idea of how much value your option could lose daily as it gets closer to its expiration.
- Vega = Recognize how responsive an option might be concerning price swings in the inherent stock.
- Rho = Mimic the way interest rates change and how that affects an option.
Option Greeks in More Detail
Delta – King of the Option Greeks
Delta is the most used of the Option Greeks. There are 3 ways you can use Delta in options trading. First, it can be used to tell you how much your options contract’s price will change. This is based on a dollar move in the underlying security. Second, it can show you share equivalency. In other words, it can show you how many shares of the underlying security your option contract is equivalent to. (Each share of stock is 1 delta, so 100 shares of stock would equal 100 positive deltas) Third, it can show you an approximation of the probability that the option contract will run out of money or expire.
Let’s unpack this so you can see exactly what Delta can do for you.
As you probably already know, calls have a positive Delta between 0 and 1. If the stock price goes up, the price for the call goes up as well. (This is assuming that no other pricing variables change.) So, if a call has a Delta of .40 and the stock goes up to $1, the price of the call will go up about $.40. Conversely, if the stock goes down $1 the price of the call will go down approximately $.40.
Now let’s look at the other side of the coin.
Puts have a negative Delta that resides between 0 and -1. So, if the stock price goes up, the price of the option will go down. (Once again, this is assuming that no other pricing variables change.) If a put has a Delta of 0.40 and the stock goes up to $1, the price of the put will drop about $.40. If the underlying stock goes down $1, the price of the put will go up about $.40. Of course, these examples are based on theory.
A good way to think of Delta is the probability that an option will expire in the money. A Delta of 0.40 usually means that an option has about a 40% chance of being in the green at expiration. If you bought the option at the right price your trade will be profitable. However, if you bought it at the wrong price…
Gamma – Holding Hands with Delta
As mentioned earlier, Gamma is based on Delta. It will give us an understanding of how Delta will change when the underlying security moves. It is the rate of change of an option’s delta if there is a $1.00 move in the underlying stock.
For example, if your contract has a 0.40 Delta and a 0.10 Gamma and then moves up $1 your option will have a 50 Delta.
Gamma is best for long option holders. The reason for this is because it accelerates profits for every $ 1.00 the underlying security moves in your favor. It also slows down for every $1.00 that the security moves against you. At the end of the day, every dollar the underlying derivative security increase, the better the returns on your capital as an investor. On the other side of this coin is the short options risk. Yes, Gamma is great for option buyers, but it’s risky for option sellers. It can accelerate losses and slow down gains.
Expiration risk is another aspect of Gamma you must consider. The closer you get to the expiration, the riskier the option gets. This means that for option buyers it’s a great deal but a very bad option for sellers. A good strategy in the use of this type of option would be to roll or close positions around 10 days before expiration.
Theta – Measuring Change of Time Decay
Theta is about time decay. It measures the change in the price of an option for a one-day decrease as the option nears expiration. So as the option matures as it nears its termination, the price will decrease and Theta will tell you how much value your security will lose each day. Selling options is a way to obtain positive Theta. On this side of the coin, selling is good for you. If you sell a put for $1.00, to close that position, you will need to buy back the same option at a lower price to gain a profit from it. So, Theta is a positive value for people who sell options because the decay of the option price will help realize a profit sooner.
Vega – Measuring Implied Volatility
Vega is the change of an option’s price for a one-point move in implied volatility. Volatility in securities is the range of price change an investment can experience over a period of time. So, if the price stays stable, the security has low volatility. If the security is volatile it will hit new highs and lows quickly. It moves erratically it can experience fast increases and dramatic dives.
So, Vega is the measure of the change of the options price for a one-point change in volatility. With this measure of the Options Greeks, traders usually refer to the volatility without the decimal point. (Example: volatility at 13% would be referred to as “vol at 13.”)
However, you should not confuse option volatility with Vega. Usually volatility in investments is based on historical data or expected leaps and downturns of the underlying security. Volatility based on historical data is in the past and known. Expected volatility gives investors an idea on the validity of a security but it is not a definite measure.
However, Vega is the sensitivity of an option to changes in volatility.
It is not THE volatility but the sensitivity to changes in volatility.
So, when option prices are bid up by people who are buying them, implied volatility will increase. When they are being sold it will decrease. With short options, we want the price of an option to decrease and with long options we want them to increase. For this reason, short options have what is known as a negative Vega and long options gave a positive Vega.
Rho – The Least Used of the Option Greeks
Rho isn’t used very much because interest rates are more stable compared to stocks. The chance that an option price will change dramatically due to the drop or rise of interest rates is pretty slim. As I’ve already hinted, Rho is the measure of an option’s reaction to changes in interest rates. Interest rate changes influence long-term options more than near-term options. More simply put, Rho will tell you how much the option contract’s value is based on a change of 1percentage point of interest rates. For example, if you have Rho of .08 the price of your option could gain or lose $0.09 for a 1%-point change in interest rates. Since interest rates have a far smaller effect on the price of options and take a longer time, Rho usually gets less attention than the other main Greeks. So, it is usually less understood and ignored by the typical option trader. Other factors make Rho less appreciated by options traders like underlying price, time, and volatility on values.
As you already know, using the Option Greeks isn’t an exact science. Trying to predict how the premium of an option might change in value as different variables in the market vary makes is tough. But you can gain insight into how option prices behave under different conditions better by understanding the Greeks. Don’t forget, taxes, margins, and commissions will change options strategies, so please keep these in mind when assessing a trade.
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