It’s important to learn option greeks if you want to gain a competitive advantage in trading options just like the professional option traders do.
The option greeks consist of – Delta, Gamma, Theta, Vega and Rho.
Each option greek has its own price sensitivity which impacts the overall price of the option differently. Some option greeks carry more weight in influencing the price of the option than other ones do.
Let’s now take a closer look at each one of the option greeks.
DELTA
The theoretical rate of change in the price of an option for a $1 dollar price move in the underlying financial instrument. If an option has a delta of .50 (at-the-money option) and the price of the underlying financial instrument moves $1 dollar, then the price of the option would be expected to move by 50 cents ($1 dollar x .50 deltas = 50 cent price move in the options price).
Options can be classified in one of three ways based on the value of the deltas:
- In-the-money options (greater than .50 deltas)
- At-the-money options (approximately .50 deltas)
- Out-of-the-money options (less than .50 deltas)
If you are doing delta neutral option trading strategies (non-directional option trading) then knowing the overall value of your delta position is crucial in rebalancing your position back to delta neutral of being approximately zero.
Deltas will either have positive or negative values depending on the following situations.
- Purchased call options and “shorted” put options will always have a positive delta value that can range from 0 to 1
- “Shorted” call options and purchased put options will always have a negative delta value that can range from 0 to -1
Why is delta important? As the delta moves closer to “1” (either positive or negative) the price of the option will start to change more closely to the change in the actual price movement of the underlying financial instrument.
Conversely, as the delta moves closer to “0” the price of the option will stop reacting altogether to the change in the actual price movement of the underlying financial instrument.
Out of all the option greeks, delta is usually the one that is most closely followed by option traders.
GAMMA
The theoretical rate of change in the delta of an option for a $1 dollar price move in the underlying financial instrument.
Gamma will either have positive or negative values depending on the following situations.
- Purchased call options and put options will always have gamma that is positive
- “Shorted” call options and put options will always have gamma that is negative
Why is gamma important? It measures the velocity of an options price (price acceleration). At-the-money options that are closer to their expiration dates will offer the greatest amount of gamma with respect to changes in the price of an underlying financial instrument as compared to in-the-money options or out-of-the-money options that are further away from their expiration dates.
As a result, the deltas for A-T-M options will change the most compared to either I-T-M or O-T-M options.
THETA
The theoretical rate of change in the price of an option as a result of time decay due to the daily change in the number of days remaining until the options expiration date.
Theta will either have positive values or negative values depending on the following situations.
- Purchased call options and put options will always have theta with negative values
- “Shorted” call options and put options will always have theta with positive values
In the world of options trading, time decay does not happen in a lineal fashion. The closer the option gets to its expiration date (especially in the last 30 days of an options life) time decay starts to accelerate at a faster rate where the option begin to lose value at a quicker rate as well.
VEGA
The theoretical rate of change in the price of an option from a 1% change in the options implied volatility. When implied volatility increases it has an effect in raising the price of an option.
Why does this happen? Because as implied volatility increases there is a greater probability that larger price movements in the underlying financial instrument will occur. As a result, there is a greater likelihood that the option will be profitable by the options expiration date.
Conversely, when implied volatility decreases, the price of an option will decrease in value due to the probability of smaller price movements.
Vega will either have positive values or negative values depending on the following situations.
- Purchased call options and put options will always have vega with positive values
- “Shorted” call options and put options will always have vega with negative values
There are some option trading strategies that can be used to exploit vega (implied volatility) to the traders advantage since there can be a disparity of vega among shorter-term and longer-term options.
RHO
The theoretical rate of change in the price of an option from a 1% change in interest rates. When interest rates increase it will increase the value of call options and decrease the value of put options. Conversely, when interest rates decrease it will decrease the value of call options and increase the value of put options.
Rho will either have positive values or negative values depending on the following situations.
- Purchased call options and “shorted” put options will always have rho with positive values
- “Shorted” call options and purchased put options will always have rho with negative values
Rho has more of an effect on the price of longer-term options than it does on shorter-term options.
Out of all the option greeks, rho is the one that is least used by option traders.
Last Thoughts About Learning Option Greeks
Having a good understanding about how the different types of option greeks work and how they impact the price of an option will give you a trading edge and help you become a better and more profitable options trader.
