If you’re familiar with options trading you’ve probably heard about the Greeks. Not the folks from Greece, but the Greek letters that are often used to measure dimensions of risk involved in an option position.
Before we dive into options Greeks, let’s review some basics about contracts. An options contract defines basic features of an option: the strike price, the underlying asset, the maturity date, and the type of contract (the right to buy or sell). This is the data you must consider when looking for the right option to trade. Besides these features, many other factors can influence your decision: the structure of interest rates, the expected dividend yield on the underlying asset, and, of course, the prospects for the evolution of the underlying asset price.
But you should also analyze the risk dimension before entering any trade. Some options rise or decline faster than others, may involve higher risks, or have a lower probability of maturing in-the-money. Some options may be more sensitive to interest rates, time-to-maturity, or other circumstances; the Greeks make it easier to analyze these different scenarios.
Options Greeks measure the sensitivity of an option price to a change in a specific variable. Unlike factual features like the strike price or time-to-maturity, the Greeks are theoretical values determined by the application of a model. It sounds complicated but is actually simple to apply.
We use models like the Black-Scholes or binomials to determine the value of an option. These models help you predict the theoretical price of an option as a function of many parameters, which include time-to-maturity, nature of the option (call/put), interest rate, dividend yield, and underlying price. The Greeks show how the price of the option is affected by changing one of those parameters while keeping all others constant.
The Greeks that traders usually look at include delta, gamma, vega, rho, and theta. We’ll analyze each one in more detail over the next few weeks, but here are some brief introductions:
Delta is probably the most used Greek in options trading. It gives you an idea of the impact a change in the underlying asset price has on an option. Delta tracks the change in the asset price for every $1 change in the underlying asset price. For example, if delta is 0.75, that means that for each $1 change in the underlying asset price, your option will change $0.75.
Gamma is correlated with delta because it measures the impact a $1 change in the underlying asset price has in delta. Delta measures the speed of change while gamma measures its acceleration.
Vega measures another important feature of an option: the impact a change in volatility has in the option value. As you know, volatility is a key part of an option price. When it declines, options may experience abrupt declines. Vega measures the change in an option price due to a one-point change in implied volatility.
Rho is related to interest rates, it measures the impact a one-percentage point change in interest rate has on the option price.
Finally, theta measures the impact of time-to-maturity. It answers the question “how much will the value of an option decline if one day passes?” As maturity approaches, the value of an option will approach its intrinsic value.
Stay tuned for the next batch of articles. We’ll start by exploring delta.
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