Options traders often refer to the delta, gamma, vega and theta of their option positions. Collectively, these terms are known as the “Greeks” and they provide a way to measure the sensitivity of an option’s price to quantifiable factors. These terms may seem confusing and intimidating to new option traders, but broken down, the Greeks refer to simple concepts that can help you better understand the risk and potential reward of an option position.
Finding Values for the Greeks
First, you should understand that the numbers given for each of the Greeks are strictly theoretical. That means the values are projected based on mathematical models. Most of the information you need to trade options – like the bid, ask and last prices, volume and open interest – is factual data received from the various option exchanges and distributed by your data service and/or brokerage firm.
As the Underlying Stock Price Changes – Delta and Gamma
Delta measures the sensitivity of an option’s theoretical value to a change in the price of the underlying asset. It is normally represented as a number between minus one and one, and it indicates how much the value of an option should change when the price of the underlying stock rises by one dollar. As an alternative convention, the delta can also be shown as a value between -100 and +100 to show the total dollar sensitivity on the value 1 option, which comprises of 100 shares of the underlying. So the normalized deltas above show the actual dollar amount you will gain or lose. For example, if you owned the December 60 put with a delta of -45.2, you should lose $45.20 if the stock price goes up by one dollar.
Changes in Volatility and the Passage of Time – Theta and Vega
Theta is a measure of the time decay of an option, the dollar amount that an option will lose each day due to the passage of time. For at-the-money options, theta increases as an option approaches the expiration date. For in- and out-of-the-money options, theta decreases as an option approaches expiration.
The Greeks help to provide important measurements of an option position’s risks and potential rewards. Once you have a clear understanding of the basics, you can begin to apply this to your current strategies. It is not enough to just know the total capital at risk in an options position. To understand the probability of a trade making money, it is essential to be able to determine a variety of risk-exposure measurements.