The Importance of Understanding the Options Greeks

How the Greeks impact various aspects of options trading

    facebook twitter linkedin


    Options Greeks are one of many factors that are important to understand when trading options. The aptly named "Greeks," are measurements relative to risk named after Greek letters. The measurements indicate sensitivity related to movements in the price of an underlying component or security, time-value decay, and implied volatility.

    This article will seek to share more about the impact of a particular option's Delta, Gamma, Theta, and Vega.

    Delta: The premium change based on the underlying stock

    The change in option price (or premium) results from a difference in the underlying equity, security, or component. Delta can range from 0 to 1.00 for calls and -1.00 to 0 for puts. The negative numbers inputs are relative to the negative relationship with the underlying stock. Therefore, the premium on a put will decrease when the stock price increases, and vice versa. A delta value close to 1.00 or -1.00 is ideal for options trading.

    On the other hand, call options represent a positive relationship between the underlying equity price. If a stock's price goes up, the call premium will follow, as long as there are no changes in implied volatility or remaining time until expiration. Conversely, if all things stay the same, the price of the call premium will decline as the equity value declines.

    Think of it like a pair of sneakers. The tread on the shoes represents the Delta, and your running speed represents the price of the underlying equity. An option with low Delta is comparable to cheap running shoes. The shoes will wear out without a lot of traction when pressure is applied. Conversely, an option with high Delta is like a brand new pair of premium running shoes. The point is that, on the high side of Delta, risk measurement means a lot of traction when it is time to apply pressure to reach the finish line.

    Gamma: The rate of change in Delta over time

    Delta is frequently changing related to an underlying equity's price. To measure the changes in Delta and provide traders with a feel for what to expect, options traders rely on Gamma. In-the-money or at-the-money options represent the highest values of Gamma, while out-of-the-money or deep-in-the-money options represent the lowest values of Gamma.

    Gamma provides a constant metric to understand the rate of change of Delta and, thus, the underlying equity price. As a result, traders can formulate the stability of Delta through a deeper understanding of Gamma when seeking supportive analysis of the likelihood of the equity reaching a strike price on or before expiration.

    Let's look at an example. A trader is considering two stock options with similar Delta values. One of the options has a low Gamma, while the other has a higher Gamma.

    Based on your understanding of the Greeks, you know that you are assuming more risk with the higher Gamma option. Why? The higher Gamma option represents a higher risk that a downside movement will significantly impact the option premium. Therefore, if you are looking for a more predictable outcome, traders will want to avoid a high Gamma as it is a sign of volatile swings.

    Think of Gamma as a stability measure. For example, suppose a trader is looking only at a Delta data point for option an price related to expiration. In this care, it is critical to also examine the option's Gamma as Gamma will represent the likelihood or probability of stability over time for that Delta.

    If you have a high Gamma and a 1.00 Delta, you may have less chance of your option expiring in-the-money versus an option with a lower Gamma and similar Delta.

    Theta: The rate of time decay based on the option or its premium relative to expiration

    Over time, an option's value may erode purely due to the passing of time. This is called time decay. Over time, the likelihood of an option to be profitable decreases. Thus, time decay accelerates as an option moves closer to the expiration date because there is less time for the necessary move for profit to occur.

    Once an options trader purchases an option contract, the countdown begins and the option's intrinsic value starts to decrease until the expiration date, at which point, the option is executed and no longer is valuable.

    While Theta is bad for options buyers, it is good for options sellers. Think of Theta as a wave on the beach. Each time a wave comes in on the beach, the wave takes a little bit of sand back into the ocean with it. The beach is the buyer side, and the wave is the seller side. Each time the wave, or seller, approaches the beach, or buyer, it is about to take value from the option. As a buyer, traders must decide if they want to execute the option or wait until closer to expiration. Like the erosion at the beach, it may not be occurring quickly, but Theta increases over time and the buyer continues to lose value.

    A negative value always represents Theta. At expiration, Theta will be zero. For longer-term options, the Theta values will vary on the negative side based on time until expiration.

    Vega: The Risk related to implied volatility or expected volatility related to asset price.

    In the same way that Delta represents price changes, Vega represents the expectation of volatility in the future. When an option has high predicted volatility, it is likely to be more expensive as there is a greater likelihood of the option landing in the money before expiration. Thus, the option is more likely to exceed the strike price.

    Implied volatility can impact the price action of the options market. Implied volatility increases when prices are up because of an increase in buyers. Options traders rely on Vega to help determine if an option price will increase or decrease relative to the level of implied volatility. A fall in implied volatility can be beneficial to sellers and detrimental to buyers.

    When you are invested in a long option and an increase of buyers bids up the price, you are in a great position to take profits off the table. If you are shorting an option, you will benefit from an increase in sellers and the price thereby being bid down. A positive Vega is excellent for the option buyer, and a negative Vega is ideal for the options seller.

    A few more critical points related to Vega:

    • An increase or decrease of Vega without price changes to the underlying component signifies a change in implied volatility
    • Higher Vega will represent quick moves in price action for the underlying equity
    • Vega will decrease as an option gets closer to its expiration

    Summary

    To better understand risk parameters and profit potential, options traders want to master the Greeks and what each data point represents. Delta measures the change in price or premium related to changes in the price of underlying equity. Gamma measures change in Delta and can help forecast the likelihood of underlying equity's price movement. Theta measures price decay over time. Vega measures risk related to the change in implied volatility or future state of volatility for an underlying equity.

    Grab your FREE Eternal Contrarian report!


     




     
    Special Offers from Schaeffer's Trading Partners