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Option Greeks Explained – Understand The “Force” Behind Options

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Introduction

 

 

In the world of option pricing, there are measurements known as the Greeks.

Just as each god of Greek mythology oversaw a certain domain, each options Greek measures a different factor that impacts the options premium.

Chief among these factors are price, time and implied volatility.

In this lesson, option Greeks  will be explained in further detail, as you’ll learn about the different options Greeks, what each attempts to measure, and how you can use this information to aid your options trading.

But before we begin, we would like you to read and agree to the Terms & Conditions of this post before you proceed any further.

Disclaimer: Invest In Wall Street is in no way financially or legally responsible for any investing decisions made by any of our readers and are, in turn, acting on their own free will. The information in this article is purely educational and should not be abused or misconstrued in any way, shape, or form.

 

Delta Greek: The Force Awakens

 

 

We’ll begin with delta.

Delta measures an option’s sensitivity to changes in the underlying securities price.

An options delta identifies how much the options premium will theoretically increase or decrease when the underlying security moves $1.00 in price.

This means a call option with a delta of 0.70 would theoretically increase $0.70 in value if the underlying security rose $1.00.

On the other hand, if the security fell $1.00, the option would theoretically decrease $0.70 in value.

Delta can also help you determine the directional risk of the options contract, or which direction the underlying needs to move for your trade to be successful.

A long call option has a positive delta, which means its premium will rise when the underlying securities price rises and fall when the underlying securities price falls.

Compare this to a long put option, which has a negative delta. This means the premium will rise if the underlying securities price falls and vice versa.

 

 

Additionally, some traders also use delta as a rough guess at the options probability of expiring in the money.

For example, a call option with a delta of 0.30 has about a 30% probability of being in the money at expiration.

While this probability isn’t exact, it can be helpful information when it comes to selling options.

Often, option sellers look at sell contracts that have a fairly low probability of expiring in the money, as these options are likely to expire worthless.

Delta could be considered the powerful ruler of the options Greeks because it takes all other Greeks, like theta and Vega into account.

Now, lets move onto our next options Greeks, gamma.

Gamma Greek – “Gamma” To The Greek On Time

 

 

Like Zeus had Hermes as his right-hand man, delta has gamma.

Gamma measures the rate at which delta changes. Gamma is useful because delta does not change at the same rate throughout the life of an option’s trade.

Gamma helps you determine how quickly delta will change as the price of the underlying increases or decreases by $1.00.

Consider a call option with a delta of 0.70 and a gamma of 0.09.

If the underlying increased $1.00, the price of this option would theoretically increase $0.70.

If the underlying increased a second dollar, the delta would now be 0.79, the previous delta plus gamma, and the price would theoretically increase $0.79.

As an option moves closer to expiration, gamma grows larger and may have a big impact on the trade.

 

 

Remember, delta and gamma measure sensitivity to price.

Let’s now meet the option Greek that would be categorized under time, theta.

 

Theta Greek: Timing The “Force”

 

 

Theta measures an option’s sensitivity to time decay, or in other words, the value that melts away from an option’s price on a daily basis.

Theta affects buyers and seller differently.

 

 

Simply  put, time decay is bad for buyers and good for sellers.

Consider a long options position with a theta of negative 0.02. This means a buyer would lose $0.02 of premium each day, and a seller would gain the same amount.

Theta increases as the trade moves closer to expiration.

 

Vega Greek: Hostile Takeover Of The Galactic Empire

 

 

The next options Greek we’ll discuss is Vega.

Vega measures an option’s sensitivity to changes in implied volatility.

Implied volatility is the portion of the options premium that expands and contracts as expectations change for the underlying security.

Let’s put it another way, if options traders and market makers expect the securities price to move significantly, implied volatility will rise, and the option will price in this expected move – whereas, if traders aren’t expecting a significant change in price, implied volatility will shrink, and the premium will decrease.

 

 

An option with a Vega of 0.05 will theoretically increase $0.05 in value for every percentage point that implied volatility rises.

Rising implied volatility will increase the value of a long options position in terms of Vega, and decrease the value of a short option’s position, all else being equal.

Rho Greek: Rho, Poe, and… Kylo?

 

 

The last Greek you should be aware of is rho.

Rho measures the options premium sensitivity to interest rate changes. This Greek tends to be less important as rates change slowly and typically have little impact on an option’s trade.

Now lets see how these Greeks can work together.

 

Put Into Practice

 

Let’s say you purchased a long call option, what would your Greek counsel look like?

Your delta is positive, which means the options value rises with the stock’s price, and gamma increases your delta as well.

However, theta is negative. This means as time passes, the value of your option decreases.

And finally, Vega is positive. So if implied volatility falls, which is common if the stock rises, your premium will also fall.

By consulting these Greeks, you can identify how various factors can  impact an option’s trade.

 

Quick Recap

In Review…

Option Greeks Explained

 

There are 5 main types of options Greeks….

 

1. Delta Greek

  • Delta measures an option’s sensitivity to changes in the underlying securities price
  • An options delta identifies how much the options premium will theoretically increase or decrease when the underlying security moves $1.00 in price
  • This means a call option with a delta of 0.70 would theoretically increase $0.70 in value if the underlying security rose $1.00
  • On the other hand, if the security fell $1.00, the option would theoretically decrease $0.70 in value
  • Delta can also help you determine the directional risk of the options contract, or which direction the underlying needs to move for your trade to be successful
  • A long call option has a positive delta, which means its premium will rise when the underlying securities price rises and fall when the underlying securities price falls
  • Compare this to a long put option, which has a negative delta. This means the premium will rise if the underlying securities price falls and vice versa
  • Additionally, some traders also use delta as a rough guess at the options probability of expiring in the money. While this probability isn’t exact, it can be helpful information when it comes to selling options
  • Often, option sellers look at sell contracts that have a fairly low probability of expiring in the money, as these options are likely to expire worthless
  • Delta could be considered the powerful ruler of the options Greeks because it takes all other Greeks, like theta and Vega into account

2. Gamma Greek

  • Gamma measures the rate at which delta changes. Gamma is useful because delta does not change at the same rate throughout the life of an option’s trade
  • Gamma helps you determine how quickly delta will change as the price of the underlying increases or decreases by $1.00
  • If the underlying increased a second dollar, the delta would now be the previous delta plus gamma, and the price would theoretically increase
  • As an option moves closer to expiration, gamma grows larger and may have a big impact on the trade
  • Remember, delta and gamma measure sensitivity to price

3. Theta Greek

  • Theta measures an option’s sensitivity to time decay, or in other words, the value that melts away from an option’s price on a daily basis
  • Theta affects buyers and seller differently
  • Simply put, time decay is bad for buyers and good for sellers
  • Theta increases as the trade moves closer to expiration

4. Vega Greek

  • Vega measures an option’s sensitivity to changes in implied volatility
  • Implied volatility is the portion of the options premium that expands and contracts as expectations change for the underlying security
  • Let’s put it another way, if options traders and market makers expect the securities price to move significantly, implied volatility will rise, and the option will price in this expected move – whereas, if traders aren’t expecting a significant change in price, implied volatility will shrink, and the premium will decrease
  • Rising implied volatility will increase the value of a long options position in terms of Vega, and decrease the value of a short option’s position, all else being equal

5. Rho Greek

  • Rho measures the options premium sensitivity to interest rate changes. This Greek tends to be less important as rates change slowly and typically have little impact on an option’s trade

 

 

 

These are the five primary options Greeks that most investors and traders pay attention to. And although it may be a good idea to memorize the effects each options Greek has on the price of the underlying security – it is NOT mandatory. This is considered to be an advanced and challenging concept of binary options that may only apply to professional traders or managers who trade these securities consistently or periodically.

Theta Greek is to time (time decay), Vega Greek is to volatility (implied volatility to be exact), and Rho Greek measures the changes in an options price due to the impact of ever changing interest rates.

But the most important Greek options that you should consider memorizing, if any, is delta and gamma – as these two Greek options have the biggest impact on the direction of price of a particular market or sector.

Both delta and gamma measure the options sensitivity to price – where the delta measures the sensitivity or “reaction” to the underlying securities price, with gamma being a “derivative” value of delta, since gamma measures the deltas rate of change.

A positive delta means that if a stock were to increase by a single dollar, the option value will also increase in value – while a negative delta would imply that the value of the stock and the option moved in separate directions, as for every change in the nearest dollar.

It is through this value that investors can measure the options effect to sudden price changes.

This can be used to the advantages of investors and traders since they can use Greek analysis to determine not only how a underlying security will be impacted, but can also make a prediction of where it may or may not go next.

I hope you have enjoyed this post and found the information to be quite useful. If you have any questions or concerns, please feel free to leave them down in the comment thread below and make sure to like and share this post.

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