Options Trading - Options Greeks

As a quick review of the variables in options pricing, the option price is determined by the price of the underlying security, the strike price of the option, the amount of time until expiration, the volatility of the underlying, any dividends outstanding and the current risk free rate of interest.

So why do experienced traders care about the “Option Greeks?” It is because they are a valuable tool in predicting what will happen to the price of an option as market variables changes. This may seem difficult to comprehend at first, but option prices do not move exactly with the price of the underlying asset.  However, any trader that dedicates the time to learn the essentials will begin to understand what factors contribute to the movement in the price of an option, and what effect each factor has.

Many professional traders will use the Option Greeks to effectively manage a portfolio of multiple options at a variety of strikes over a variety of timeframes.  In order to create a neutral portfolio, market professionals will also use the Greeks to ensure that their market exposure is effectively hedged and adjusted accordingly.

As for the day trader or investor, the Greeks represent a means of understanding why and how an options price changes as any one of the variables change.

The 5 commonly referred to Options Greeks are the Delta – which measures the correlation of the price change in the option to the price change of the underlying stock.  Gamma - this measures the rate of change of the Delta.  Vega, which measures the change in volatility, Theta – which measures the change in Time and Rho which accounts for the change in interest rates.

The first and most commonly referred to Greek is the Delta.  As mentioned, the delta is the rate of change in the option price relative to the rate of change in the underlying stock.  This is important to understand since many option strategies are tailored to profit from correctly anticipating the price change of the underlying security.

For an example of Delta, we have a stock that is priced at $50.00 and an at-the-money option at the $50.00 strike.  There are 30 days until expiration; the call option is priced at $2.32 with a Delta of 0.53.  The delta reflects the expected change assuming no other variables change.

If the price of the stock increases by a dollar to $51.00, we can anticipate that the call option would increase from $2.32 to about $2.85.

In the same respect, if the stock price was to drop from $50.00 down to $49.00, we can anticipate that the call option would decrease in value from the $2.32 to about $1.79.

Notice that in both situations the price has changed by the amount of the Delta. Some of the key characteristics of the Delta are:

At the point that option delta reaches 1, the call option would start replicating the price movement of the underlying stock almost dollar for dollar.

When we are looking at the delta of a put option, the deeper in-the-money the option gets, the delta will approach minus 1. Put options will always have a negative delta.

The next Option Greek is the Gamma.  Since the delta is always changing, there needed to be a way to measure that progressive change. As a result, the Gamma was created as a means of quantifying the rate of change of the delta. This is primarily utilized by professional traders to adjust delta hedged portfolios.

The next Greek is the Vega.  The Vega is the measure of the change in the option price relative to the percentage change in implied volatility.

For this example of Vega, we have a stock that is priced at $50.00 and an at-the-money option at the $50.00 strike.  There is 30 days until expiration.  The call option is priced at $2.06 with an Implied Volatility of 35% and a corresponding Vega of 0.057.
If the implied volatility of the stock increased by 1 percent to 36%, we can anticipate that the call option would increase from $2.06 to approximately $2.12, the amount of the Vega.

In the same respect, if the implied volatility was to drop from 35% down to 34%, we can anticipate that the call option would decrease in value from the $2.06 to approximately $2.00.

The next Option Greek is Theta.  The Theta is a measure of the change in the option price relative to the change in time to maturity. Every day that passes, an option will lose some of its value, the Theta measures that rate of decay.

For this example of Theta, we have a stock that is priced at $50.00 and an at-the-money option at the $50.00 strike. There is 30 days till expiration. The call option is priced at $2.06 with a Theta of minus 0.041. If the number of days until expiration drops from 30 to 29 days, the option would decrease from $2.06 to approximately $2.02, the amount of the Theta.

The final Option Greek is Rho. Rho is a measure of the change in the price of an option relative to a change in the risk-free rate of interest. This particular Greek is far more relevant on longer term options as the interest rate effect on a short term option is less evident.

For this example of Rho, we have a stock that is priced at $50.00 and an at-the-money option at the $50.00 strike. There is 30 days till expiration. The call option is priced at $2.06 with interest rates at 3.00% and a Rho of 0.02. If interest rates were to rise to 4%, the option price would increase from $2.06 to $2.08, the value of Rho.

In the same respect, if interest rates were to drop from 3% down to 2%, the option price would decrease from $2.06 to $2.04.
In conclusion, by learning the option Greeks, an investor or trader is able to understand why an option is or is not moving in correlation with the underlying security.

By understanding the variables that influence option prices, the day trader or investor will have the confidence necessary to integrate options into their portfolio and take advantage of many strategies to help meet their objective.

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