Learn The GREEKS: Option Trading
The greeks is a term for multiple measuring factors which can determine and predict the price movement of option premiums which allows you to understand the risk exposure of those options. In simple english - these greeks - and there are 5 we will go over - are there to help us measure how an option premium price will be affected in the future based on different things.
DELTA: Delta will be used to determine how much the option price of a particular contract will move - either up or down depending on how the stock price moves. So the stock price goes up? Well, how do we know what the option price will then be? We use delta! Delta is defined as the expected change in an options price relative to $1 movements in the underlying stock price. So again, Delta is going to help us determine how the option price will move for every $1 the stock moves. Delta values you’ll notice will go from 0 to +1 with calls, and 0 to -1 with puts. Thats the number that the premium price will increase or decrease by.
GAMMA: So now that we understand Delta - and how the price of the option is affected by Delta we can now understand gamma - because gamma affects delta - and delta affects the price of the option - so through this weird chain of events gamma affects the price of the option. K - Gamma is the rate of change of an options delta relative to a 1 point move of the underlying stock. So just like Delta, when the stock moves up $1, the option price is affected. So lets take an example - we have a stock trading at $10 with an option contract price of $2. The option delta is .5 and the gamma for the option is .1 - Now lets say the $10 stock increases to $11 - a 1 point move in the stock. The gamma of the option, which is .1 will affect the delta of the option which is .5 .1+.5 is .6 - so now the new delta of the option at the $11 price is .6 which in turn will affect the overall price of the option.
THETA : One very important thing to understand about options is that all options lose value as they get closer to the expiration date if all other things remain constant. So you buy an option - you’re always fighting time - and that option is losing value every day, every week, every month until at expiration there is only the intrinsic value left of that option. This is due to Theta - or Theta decay. Theta refers to the rate of decline in the value of an option due to the passage of time. Theta is usually expressed as a negative number and that number tells you how much value the option will lose every day until expiration. Now that you know all this you can see how selling options is favorable - because you can sell an option and just let Theta decay do its thing - and as the option price decreases - something it does naturally - you, as the option seller make money.
RHO : Rho measures the price change of an option in relation to risk-free interest rates. When speaking of risk-free interest rates we are talking about something like U.S. treasury bills. For example - if an option has a rho of 1.0, then for every 1 percentage-point increase in interest rates, the value of the option will increases by the amount of Rho - which is 1.
Remember, Call options generally rise in price as interest rates increase and put options decrease in price as interest rates increase. So, call options have a positive rho, while put options have a negative rho. Alrighty got that out of the way.
VEGA - Vega represents the amount that an option contract's price changes based on a 1% change in the implied volatility of the underlying stock. So just like all the other greeks, the option price is affected by something and in vegas case that something is it’s implied volatility. I think you’re getting the hang of this now I can feel it. For every 1% move up or down in implied volatility, the option price will move up or down by the amount of Vega.
