If you’ve been looking at option price quotes and considering making a trade, you’ve probably seen the term “Greeks” and you might be wondering what it all means.
In a nutshell, the Greeks are a way to know how the option’s price will behave in various circumstances.
They’re really fairly simple once you understand them. Let’s take a look at what they mean and how we can we can use them to guide us toward the options we want to trade.
Delta – This is a measure of how sensitive the price of an option is to movement in the underlying stock. It refers to how much the option’s price will change if the underlying changes by 1 point. It’s expressed as a percentage between 0 and 100. For instance, if a call option has a 0.40 delta and the underlying rallies $1, the value of the option will rise $0.40. Options that are at-the-money generally have a delta of 0.50. Out of the money options have a smaller delta and in-the-money options have a larger delta. Puts have a negative delta, meaning their prices move in the opposite direction as the underlying stock.
(Note: Although delta is a percentage, in trading vernacular it’s usually expressed as simply a number between 0 and 100. For instance, an option with a delta of 0.40 is generally referred to as a “forty delta” rather than a “point four zero delta.” Also, although puts have a negative delta, we don’t generally don’t say that they are negative, it’s simply implied. A put with a delta of -0.40 is simply referred to as the “forty delta put.”)
Sometimes traders will refer to delta as the percentage chance that that option will expire in-the-money. Though this is not strictly mathematically correct, it’s close enough that you can actually treat it that way.
Gamma – This is a measure of how sensitive the delta is to movement in the underlying. Options that are at the money will see their delta change much more than options that are deeply in or out of the money. Options that have less time left until expiration will have a delta that changes more than options that are farther out. These options have higher gamma.
Theta- This is the amount of value an option loses as a result of time passing if nothing else changes. It’s commonly expressed in dollars per day. An option with a theta of $0.25 will lose 25 cents of value as one day passes. As was the case with Gamma, options that at close to at-the-money and with less time to expiration have the highest theta. The amount of theta increases as the option nears expiration. (In the extreme, picture that an option that is 1 cent out of the money will still have a significant amount of value if there’s plenty of time until expiration – because there’s still a good chance it will end up in-the money - but at the moment of expiration, if it's still out of the money, it loses all of it’s remaining value and becomes worthless.) Theta is sometimes also called “time decay.”
At the end of last week, we saw traders sell 10,000 each of puts and calls in range-bound Groupon (GRPN - Free Report) , apparently hoping to take advantage of the time decay, collecting the premium and hoping they both expire worthless. With the stock up 9 cents today during an uneventful day, the trade looks like a big winner already.
Vega – This is the sensitivity of an option’s price to a change in volatility. Expressed in dollar terms, it describes how much an option’s value goes up or down when the market estimate of implied volatility changes. Vega is always positive. Calls and puts both increase in value as volatility increases. A vega of $0.30 means that if implied vols increase by 1% - say from 40% to 41% - the value of the option will increase by 30 cents. Longer dated options have higher vega than those that are about to expire. The more time left until expiration, the likelier it is that the option might end up in the money. If the underlying stock moves or is considered likely to move, all options get more valuable.
Rho – This is the sensitivity of an option’s price with respect to interest rates. Rho increases with time. Longer dated options have a greater sensitivity to interest rates. In the simplest possible terms, because an option can replicate a position in the underlying stock, it’s price (or theoretical value) includes a premium identical to the cost of borrowing money and owning the underlying itself. Except for very long-dated options, Rho tends to be very small. Interest rates don’t affect the value of the heavily traded short dated options very much.
Next up, we will use the Greeks – especially Vega – to construct option trades where the odds of winning look to be on our side. Stay tuned…
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