The option Greeks are not gods that option traders worship. Options are derivatives of stocks. And the Greeks explain how these derivatives move.
Understanding Options Greeks can help traders select certain options and better understand the risks involved.
With stock options, each option is based on an underlying stock or an ETF. Moves the underlying ripple into the option. The Greeks are used to describe the relationship between the price movements of the underlying assets and the price movements of the option premium. If you’re not sure what a premium is, it’s basically the price of the option.
We’ll divide our discussion of the Greeks into three categories: price, time, and implied volatility. These are the categories each of the four Greeks falls into. Let’s begin.
Delta is a Greek award. It describes how much an option’s premium changes based on a $ 1.00 price movement in the underlying stock. Delta is probably the most widely watched Greek and one of the easiest to understand.
To see how Delta works, let’s look at an option that has a price of $ 0.50. In other words, it has a $ 0.50 premium. If the underlying stock increases by $ 1.00, the option’s premium increases from 0.50 to 1.00.
Delta is also used to describe the likelihood that an ITM (in the money) option will expire. For example, we buy the call option ABC Jul09 50. It has an exercise price of 50 and the underlying price is 49.50. The delta of this option is 0.75. The delta tells us that by the time the option expires (July 9th), there is a 75% probability that the price of the underlying will be at or above 50.00.
In summary, the delta increases as the underlying stock price approaches the option’s strike price (closer to ITM) and decreases as the stock price moves away from the option’s strike price (further OTM or out of the money).
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Gamma is another price-based Greek and is a second derivative. It measures the rate of change of the delta. What do we mean by the second derivative?
As mentioned earlier, options are a derivative of the underlying stock. When you append a measurement to a lead, you get another lead (i.e. the second lead).
How does gamma work? After the first move in the underlying asset by $ 1.00, add the delta and gamma to find the next USD-based move. Let’s say gamma is 0.05.
From the earlier delta example, after the initial stock move of $ 1.00, the delta rises from 0.50 to 1.00. We can find the next increase in premium on the next underlying move of $ 1.00 by adding gamma to the delta: 0.50 + 0.05 + 1.00 = 1.55. This tells us that on the second dollar move we should expect a premium of 1.55.
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Now we’re moving out of the price-based Greek and into the time component that brings us to theta. Theta measures the premium that an option loses with each passing day. If the theta for an option is 0.02, we should expect the premium to decrease by 0.02 every day.
In a simple example, an option has a premium of $ 1.00. After four days, if only theta affects the price, it is worth (0.02 x 4) 0.92. Of course, options are complex creations, and far more than just theta affects the option price. But theta certainly has an impact on the price of the option.
It is important to know that the option premium will decrease or expire faster as we near expiration (i.e. expiration). During the last 30 days before expiration, theta is in full swing as the option’s premium falls the fastest during this period.
Time Decay works against option buyers and for option sellers. Traders who buy calls or puts must place the underlying asset above the call strike or below the put strike before expiry. Otherwise the option expires worthless.
Time is not that important to option sellers. As long as the underlying does not breach its strike price, it collects the full premium if the option expires on expiry to zero (ie expires worthless).
Vega is a derivative measurement based on volatility. It measures the implied volatility (IV). More precisely, how much the premium changes with every 1% movement in implied volatility.
As an an example:
Prem = 1.00
Distance = 0.05 0.0
If the IV drops by 1%, the premium drops to 1.00 – 0.05 = 0.95.
Longer term options have a higher vega. For example, an option with 45 days to expire has a higher vega than one with just 10 days to expire.
Bring everything together
How does someone use the Greeks option? As mentioned earlier, Delta is probably the one you are most interested in when doing hand calculations or keeping an eye on the Greeks.
That doesn’t mean the others aren’t useful. But since options are a purely mathematical creation, the Greeks are best used in models. Models are able to compute numbers quickly and spit out option price ranges for certain data.
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What about Rho, Vanna, and Charme?
There are a few other strange names to mention and another Greek one. Rho is an option Greek but is less mentioned when talking about option Greeks. Rho is tied to a 1% rate hike. As you can imagine, interest rates don’t change that often. Unless you have a long-term option, Rho just doesn’t count.
Delta hedging is another option concept. I only mention it because it could be confused with the delta smell. However, this is not exactly what delta hedging is. Traders use delta hedging to secure their (order) book.
They use Delta to determine if their book is neutral. For example, a dealer who has 10 long instruments with a delta of 0.70 and short 10 with a delta of -0.60 is long with a delta of 0.10. This dealer is likely to short more and bring his delta to zero.
The mechanics behind it use stranger names called Vanna and Charm. Vanna is volatility exposure and Charm is time exposure.
There is also a minors option. We haven’t discussed them here because the Greeks rarely mention them. Their names are Lambda, Epsilon, Vomma, Vera, Speed, Zomma, Color and Ultima.
The little Greeks get into the matter of “derivation of derivation of derivation”. If you followed that, it will mean second and third derivatives. At some point the higher-level derivatives become useless to humans because we cannot really perceive their results. All models are from there.
But the main Greek option discussed above can be understood by the average trader with just a little study and practice. And once you understand what these Greeks are and how they work, as an options trader you can make faster, more data-driven decisions.
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