December 13, 2013

Have you ever wondered how the value of an option is computed after an option is bought? Has it caught you by surprise when an option’s value rises steadily by a certain amount day after day then just suddenly plummets?

In order to make wise decisions on options, you need to understand the Option Greeks. In particular, you need to understand Option Delta, Gamma, Theta and Vega.

Yes, Greeks. But don’t be scared! This type of Greeks is not going to bring you into a historic debt-crisis. This type of Greeks is going to make you a more successful Options Trader, thus, more money!

Here are the 4 Option Greeks that you will need to keep in mind in tracking your options:

1. Delta
2. Gamma
3. Theta
4. Vega

Delta

Options are derivatives. As such, they only “derive” their values from an underlying asset/stock. Thus, when the price of the underlying asset changes, the value of the option will naturally change as well.  However, it is to be noted that in almost all cases, the amount of change of the underlying asset ‘s value will not be necessarily the same as the amount of change of the option’s value. However, the relation between the value of an option and the value of an underlying asset can be measured.

Delta measures the sensitivity of an option’s value in relation to the underlying asset. Delta pertains to the amount of option price expected to change for every \$1 of change in the underlying asset’s value. Call options have a positive Delta while put options have a negative one.

For example, you bought a call option for the stock of ABC Company. At this point, let us say that the stock has a market value of \$100 while the option is worth \$20. When the price of the underlying asset goes up by \$1, it does not mean that the value of option will also rise by \$1. When the Delta displayed for such option at that point in time is 0.60, that means that if the price of ABC Company moves from \$100 to \$101, then the Option price will move from \$20 to \$20.60. If the price of ABC Company moves from \$100 to \$99, then the Option price will move from \$20 to \$19.40.

If the option bought was a put option instead of a call option with a Delta of -0.60, then a rise of \$1 would have decreased the option’s value by \$0.60 while a fall of \$1 would have increased the option’s value by \$0.60.

In general, options with a Delta of 0.50 or 50% are considered to be at the money. Options with a Delta of 0.80 and above are considered deep in the money while options with a Delta of 0.20 or less are out of the money.

However, a Delta as an indicator is not constant for an option. A delta is only indicative of an option’s sensitivity for the current market price. If the market price changes, the Delta will also change. For example, if the stock price of the ABC Company moves from \$50 to \$51 and the option’s value changes from \$1 to \$1.60, then there is a new Delta. The Delta may already be 0.70.

Gamma

Since Delta is such a significant indicator, Option traders are also interested in knowing how the Delta may change when the price of the underlying asset changes.  Gamma measures the sensitivity of a delta in relation to the underlying asset. Gamma pertains to the rate of change in Delta for a \$1 change in the stock price.

For example, if an option has a value of \$20 and the underlying asset has a market value of \$100, Delta is shown to be \$0.60 and Gamma at 0.20. This means that when the underlying asset’s market value moves up by \$1, then the option will increase in value by 0.60 and become \$20.60. The new delta will become 0.80 which means that if the underlying asset’s price will move another dollar up, then the Option will increase from \$20.60 to \$21.40.

Theta

Theta is popularly known as Time Decay. It indicates the value of the option that will melt away due to the passage of time. Theta is one of the most important indicators that Option traders should keep an eye on because an Option’s value will naturally become zero when the expiration time arrives. . For at-the-money options, Theta rises as an option approaches the expiration. For in-the-money and out-of-the-money options, Theta falls as an option approaches expiration.

Vega

Vega is not a Greek letter but is still part of the most important indicators in tracking Options. Vega measures the sensitivity of the price of an option to changes in volatility. An increase in volatility will increase the prices of all the options on an asset, and a decrease in volatility causes all the options to decrease in value.

However, each option has its own Vega and how much each will react to volatility is different from one another. The impact of volatility changes is greater for at-the-money options than it is for the in- or out-of-the-money options. Furthermore, while Vega affects calls and puts similarly, it does seem to affect calls more than puts.

Learning the Greeks might seem hard at first but will sure to come in handy when you get the hang of it.