by Amanda Harvey
Option greeks are values that are assigned to measure the impact that certain external factors are likely to have on the value of an option. These values are calculated with mathematical formulae and are represented by characters from the Greek language, hence their name. The greeks are also described as options risk measures.
While there are more than a dozen option greeks, there are only four or five that most traders really need to have an understanding of. These main greeks are Delta, Vega, Theta, Gamma and Rho. They measure the relationship in price, sensitivity to volatility, passing of time, rate of change in Delta, and sensitivity to the interest rate respectively.
These measures have a great impact on options pricing, and pricing models such as the Black Scholes Model implement the main option greeks in their calculations.
Delta is used to measure the probable movement of price for an option in relation to the movement of the underlying asset. Call options have a positive Delta which is expressed with a number between 0 and 1. Puts show a negative Delta of between 0 and -1. The Delta equates to a percentage of the price movement of the underlying stock, so in theory, a call option with a Delta of 0.6 will increase 60 cents for every dollar that the stock increases. For a put option, a Delta of -0.4 means that if the stock price drops by $1, the option will theoretically gain $0.40.
The closer to 1 the Delta value of a call option is, the greater its value, and the greater chance it has of expiring in the money. The same applies for a put option with a Delta approaching -1.
Delta tends to increase closer to expiration dates for options that are near- or at-the money. Brokers will usually provide up-to-date Delta values for a trader’s options, as being aware of this measure is important to the trader’s decisions.
The second of the key option greeks, Vega, is used to measure the effect of implied volatility on the value of the option. Volatility is very important to option trading, as many option strategies are highly dependent on volatility. Option pricing is also very closely tied to volatility, and an increase in volatility equates to a rise in option values.
Vega is shown as the rise or fall in value that an option is expected to experience in relation to a rise or fall of one point in volatility. A relatively high Vega of 0.2 translates to an increase of $0.20 in the option value if the volatility rises by one point, and a decrease in option value of $0.20 if the volatility drops one point.
The next of the option greeks is Theta, and this greek is used to measure the decrease in option value in relation to the passing of time. This diminishing of value in proportion to decreasing time before expiration is known as time decay. The Theta rating represents the amount of value that an option is expected to lose each day. Generally the longer amount of time before expiration, the lower the Theta, which means that the option is losing less time value per day. This is because more time to expiration means a greater possibility of the option expiring in-the-money.
Gamma is not one of the first-order options greeks, however it is an important second-order greek, and should be considered when assessing options risk. Gamma measures the speed at which Delta changes when an underlying stock price changes. A higher Gamma rating is generally positive if the stock price is moving in favor of the trade, as the option can rapidly respond to the movement in stock price.
Rho is the last of the option Greeks to be covered in this article, and although Rho is a first-order greek, and it is applied to the Black-Scholes Model, it actually has less impact on option value than the other greeks previously detailed. Rho measures the sensitivity of the option to the interest rate, and it is usually expressed as the amount of money that the option will lose or gain in value with the raising or lowering of the interest rate by 1%.
By having a basic understanding of the option greeks, a trader is better able to assess the true value of an option and its level of risk, and accordingly make intelligent trading decisions.