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As a beginning options trader, you have likely heard of “Option Greeks.” The Greeks are fundamental metrics we use to make informed trading decisions and to gauge our trades, portfolio risk, and profit potential.
The Greeks measure how an option price or premium will change in response to changes in any of the five inputs of the option pricing model. Option prices often do not correlate directly with the underlying stock price; this makes identifying what, exactly, is changing the price of an option difficult. Are the stock price or time to expiration changing the option price? Is option volatility increasing? The Greeks help us answer these questions and understand what is driving changes in the option price.
Delta is the first Greek to master and is the most versatile. Delta measures how much the option price will change for every $1 move in underlying stock price.
● Delta ranges from -1.00 to 1.00
● Buying calls have a positive delta – an increase in the underlying stock price will increase the price of the call option
● Buying puts have a negative delta – an increase in the underlying stock price will decrease the price of the put option
● Selling options flips the sign of delta – selling calls will have negative delta and selling puts will have positive delta
● The sign of delta indicates the directional exposure to the underlying stock. A positive delta indicates a bullish exposure (want the stock to go up), while a negative delta indicates a bearish exposure (want the stock to go down). A delta of zero indicates a neutral exposure to the market.
● At-the-money options have a delta of .50 regardless of call or put
● As the option moves in-the-money, delta go towards +/- 1.00
● As the option moves out-of-the-money, delta go towards 0
Delta can also be used to estimate the probability that the option contract will expire in-the-money. For example, if the delta is .50, the option has a 50% probability of expiring in-the-money. Likewise, if the delta is .20, the option has a 20% probability of expiring in-the-money. This makes sense because stocks have a 50/50 probability of going up/down, hence at-the-money options with a delta of .50 have 50/50 probability of going in-the-money.
Lastly, delta estimates the number of shares you have exposure to. A delta of .35 means you have exposure to roughly 35 shares of stock. This information can be useful if you are looking to hedge or offset your position. Let’s say you are long 100 shares of stock (100 deltas), but would like to partially offset this position to reduce your overall risk in the trade. You could sell a .30 delta call (-30 deltas), which would effectively hedge 30% of your position. The net effect would reduce your exposure of 100 shares of stock down to 70 shares of stock (70 deltas).
Gamma measures the rate of change of delta for each one dollar increase in the underlying asset. Delta is not a static number. In fact, it can increase or decrease as the stock price fluctuates. Because delta is such an important metric in understanding risk and probabilities in a trade, we use gamma to gauge the magnitude of the change in delta as the stock price goes up or down. Gamma can also be thought of as acceleration, while delta can be thought as speed.
● Gamma is the highest for at-the-money options and decreases as you move in-the-money and out-of-the-money.
● Gamma is a positive number for both long calls and long puts.
● Like delta, if you sell the call or put option, you will also flip the sign of gamma, making it a negative number.
● Call option currently priced at $3.50 and has a delta of .40 and a gamma of .10
● We know that if the stock price moves up $1, the call price will increase to $3.90 (original option price plus delta)
● If the stock price then moves up another $1, the call price will increase by .40 plus the additional .10 from gamma. The call price would become $4.40 (original option price plus delta plus gamma).
Theta is the third Option Greek. Theta measures time decay. It measures how much the option price will change for each day that passes.
● Buying calls and puts have negative theta, meaning they lose money every day.
● Selling calls and puts have positive theta meaning they make money as time goes by.
● Theta increases exponentially towards expiration
● At-the-money options have the highest theta
● Theta for in-the-money and out-of-the-money options gradually decrease as time goes by
Theta is the reason why you can buy call options, be right on direction, and still lose on the position. This is because theta is working against you. Theta is one of the major reasons why we at Option Posts choose and build strategies that are built on option selling. When selling options, we have time on our side and theta working to our advantage.
Vega measures the change in the option price for every 1% increase in implied volatility.
● Long calls and puts have positive vega, meaning they make money when implied volatility increases
● Short calls and puts have negative vega, meaning they lose money when implied volatility increases
● Implied volatility affects longer-dated options more than shorter-dating options
● At-the-money options have higher vega when compared to in-the-money and out-of-the-money options
Implied volatility and vega are some of the most important concepts to master when trying to trade short premium strategies. Those who master implied volatility will understand where we get our edge in trading options.
Rho measures the change in the option price for every 1% increase in risk-free interest rates (Treasury rates). It tells how the option price will be affected if interest rates go up or down.
● If interest rates go up, call prices increase
● If interest rates go up, put prices decrease
For the type of trading we do at Option Posts, rho does not play a factor at all. Rho generally affects longer-dated options (six months to a year). Since we trade 45-day or less options, rho has a miniscule effect on the options we trade. For this reason, we don’t typically look at or consider rho as a factor in our trading decisions.
Option Greeks, including delta, gamma, theta, vega, and rho, are all tools to understand how the options price will change when one of the inputs into the option pricing model changes. This is not as easy as looking at the underlying stock price; the Greeks provide us with an essential method of understanding the effects of changes in stock price, time decay, volatility, and interest rates on the option price.
Don’t worry: you don’t have to calculate any of these numbers on your own. Any good options trading brokerage platform will calculate all the Option Greeks for you.
If this explanation of Option Greeks Explained was at all helpful, let us know in the comment section below!
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