Option Greeks: The 5 Factors to Measure Risk | Espresso

The Option Greeks Explained

Many variables that affect an option's pricing might either benefit or damage traders based on the types of positions they have taken. The so-called "Greeks"—a group of measures so titled “ after the Greek letters which indicate them that also show how delicate an alternative is to changes in implied volatility, movements in the cost of its underlying stock and time value decay among the factors that affect options costing. Professional traders are aware of these factors.

Published on 05 January 2023

In this article, we have option greeks explained in detail. So you can get a better understanding of how they work and how they can impact your options trading.

What are the Option Greeks?

Option Greeks are monetary indicators of how sensitive the cost of an option is to the factors that determine it, including volatility or the value of the underlying securities. The option Greeks are used in the sensitivity analysis of an alternative or portfolio of choices and the analysis of a choices portfolio.

Many investors view the metrics as being necessary for making wise selections while trading options. The major Greek fraternities are Delta, Gamma, Vega, Theta, and Rho.

1.      Option Greek Delta

The term "delta" refers to the projected change in an item's price for each $1 variation in the underlying securities or index value. A Delta of 0.40, for instance, indicates that the cost of the option should vary by $0.40 with every $1 variation in the value of the underlying assets or index. This implies that the larger the price shift, the greater the Option Delta, as you may have guessed.

The amount of share of the underlying assets that the option acts like can be considered Delta. Consequently, a Delta of 0.40 denotes that, given a $1 change in the underlying stock, the option is expected to profit or lose equivalent to 40 units of the stock.

2.   Theta

If all other variables stay the same, theta informs you how significantly the cost of an option would drop each day as it expires. Time decay is the term for this form of price depreciation over time.

Time-value degradation is not continuous, therefore as expiry draws near, the pricing corrosion of at-the-money (ATM), considerably out-the-money (OTM), and in-the-money (ITM) options often increases, whereas that of extremely out-of-the-money (OOTM) options typically falls.

3.   Gamma

Gamma depicts the variation rate in an option's Delta with time, whereas Delta represents a moment in time. If you can recall your high school physics course, you could consider Gamma as acceleration & Delta as velocity.

Gamma is the amount that changes in an option's delta for every $1 shift in the value of the underlying assets in real life. The gamma of long options is favorable. Whenever an option is in finances, it has a maximal gamma. Gamma, on the other hand, falls if an option is deeply in the money or out of the money.

4.   Vega

Vega calculates the rate of fluctuation in an option's price for every % variation in the underlying stock's implied volatility. Although Vega isn't a genuine Greek letter, it is used to indicate how significantly the value of an option must change as the volatility of the underlying assets or index rises or falls.

If Vega is neglected, you can end yourself paying too much for your selections. When choosing a strategy, consider purchasing options whenever Vega is less than "normal" levels & selling options if Vega is well above "normal" levels, all other things being equal. Comparing implied volatility to historical prices is one method to find out.

5.   Rho

Rho is positive for call options and negative for put options. This is because a higher interest rate decreases the present value of future cash flows, which hurts the value of a call option (since it allows the holder to buy the underlying asset at a fixed price in the future). On the other hand, a higher interest rate increases the present value of future cash flows for a put option (since it allows the holder to sell the underlying asset at a fixed price in the future).

For example, let's say you own a call option on XYZ stock with a strike price of $50. The current interest rate is 5%. If the interest rate rises to 6%, all else being equal, the value of your call option will decrease. This is because the present value of the future cash flows you'll receive from exercising your option is lower when interest rates are higher.

The Bottom Line

The Option Greeks are measures of an option's price sensitivity to various factors. These include changes in the underlying security's price, time decay, volatility, and interest rates. By understanding how these factors affect options prices, traders can make more informed decisions about when and how to trade.

Chandresh Khona
Team Espresso

We care that you succeed

Bringing readers the latest happenings from the world of Trading and Investments specifically and Finance in general.