Trying to predict the price action of a single option or a position involving multiple options as the market changes can be challenging. This is because option prices do not always move in tandem with the price of the underlying asset. As such it is important to understand what factors contribute to the movement in the price of an option and the effect they have.
Options traders often refer to the delta, gamma, vega, and theta of their option positions. This provides a way to measure the sensitivity of an option's price to quantifiable factors. Though these terms may seem confusing and intimidating to new option traders, when deciphered, the concepts can help you better understand the risk and potential reward of an option position.
Let's have a quick look at Greek options and how you can use them to understand the volatility of an option position.
Greeks in options trading are different ways to measure an option’s position. They refer to a set of calculations you can use to measure different factors that might affect the price of an options contract. Options traders use Greeks to describe their option positions and make informed decisions about which options to trade, and when to trade them.
Calculating the Greeks isn’t an exact science. Traders use a variety of formulas, usually by a mathematical model. Albeit, these measurements are usually all theoretical and their success depends on the efficacy of the models.
Delta is a measure of how much an option's price changes if the underlying stock's price changes. It evaluates the price change of the option in response to every $1 change in the underlying stock as a decimal. For example, if an option has a delta of 0.30. This implies that the option’s price will move $0.30 for every $1 move in the stock’s price.
Delta also gives an options trader an inkling of how much he can expect to make from a particular trade. Based on the example above, the trader has a 30% chance that his option will expire in the money.
Gamma tracks the sensitivity of an option’s Delta. It gives an estimate of how much the Delta might change if the stock price changes. Think of an option that can be thought of as a car going down the highway, with its speed as Delta and its acceleration (change in speed) as Gamma. Using our earlier example, if the Delta changes to 0.5 from 0.3, then gamma would be 0.2.
Theta measures an option’s sensitivity to time. It gives investors a sense of how much an option’s value decreases as it gets closer to expiration. Theta is typically expressed as a negative dollar amount and represents how much value an option loses each day as it approaches expiration. Using our “car on a highway” analogy, Theta can be thought of the wear and tear on the car as it approaches its destination
Vega is a measure of an option’s sensitivity to implied volatility. Simply put, Vega helps you understand how sensitive an option might be too large price swings in the underlying stock.
Markets can be volatile, and securities (and their derivatives) are affected by that volatility. Vega attempts to measure how much an option’s price will change as it relates to the underlying security’s volatility. The price swings from volatility can change an option’s value, which in essence is what vega is measuring—not the implied volatility itself. Like delta and gamma, vega is expressed as a number, rather than a dollar figure.
Options traders may turn to second-and third-order derivatives that signal changes in those risk factors based on changes in other variables in addition to the risk factors listed above. While they are less often employed, they are nonetheless valuable for gaining a thorough understanding of an options position's risk profile.
Lambda, epsilon, vomma, vera, zomma, and ultima are some of these minor Greeks. These Greeks have an impact on things like the change in delta with a change in volatility, and so on. While these risk variables are less well-known, they are increasingly being incorporated in options trading methods because computer software can swiftly compute and account for these complicated and often esoteric risk factors.
There's no getting around it: Options and the Greeks can be confusing, and they may not be the greatest financial approach for newcomers. However, experienced traders or those willing to invest the time to learn how to comprehend options find them to be a useful tool in developing an investing plan.
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