Option Greek Basics
Options traders often refer to the delta, gamma, rho, vega, and theta parameters to describe option positions. These terms are collectively known as the Greeks. Understanding option greeks can make or break a trader. It helps you build your option trading strategies, entry and exit points.
What are option greeks anyway?
Option greeks are a way to gauge an option’s sensitivity to the underlying stock, interest rates, market volatility, and time continuum.
Delta is the amount an option price is expected to move based on $1 move up in the underlying stock. Calls have positive delta, between 0 and 1. Puts have negative delta, between 0 and -1.
Gamma is the rate of change in delta based on a $1 change in the stock price. Gamma is the additional money made or lost for each incremental dollar, higher or lower. You can consider Delta as speed, and Gamma as an accelerator.
Theta is the time decay. It is enemy number one for the option buyer. On the other hand, it is usually the option seller’s best friend. Theta is amount the price of calls and puts will decrease every single day as option approaches its expiration date Theta is always negative.
Vega is the amount a call and put price will change for every 1% change in Implied Volatility or IV. Vega affects time-value of an option price. IV is the most critical element of an option pricing model because its the only unknown among all option greeks.
Rho is the lesser important greek for option traders and is not that significant to vast majority of option trading strategies. It measures how the price of an option will move as interest rates change. Its lesser important as interest rates don’t move that significantly. For example a price of an option will increase by $0.01 for each interest rate point increase, and decrease by $0.01 when interest rates go down by a percentage point.
Read and interpret Option Greeks from your trading tool
Lets walk through an example to give you a better idea. This is a screen grab from Fidelity’s Active Trader Pro. TD Amertitrade’s Think or Swim is another great alternative. I find Fidelity’s Active Trader Pro easy to read.
SPDR S&P 500 trust is an ETF that is heavily traded in NYSE. It is designed to track S&P’s 500 stock market index and the fund is the largest ETF in the world. Option greeks are better understood by going through an example of a high volume traded asset.
SPY is currently trading at 280.83. For May 15 calls, the option contract has a delta of 0.5297. If SPY moves by $1 then the option’s price should increase by $0.5297 or $52.97 per contract.
It gets a little more complicated because delta will grow as a stock option goes further in the money or ITM. If the $280 strike price call has a delta of 0.5297 that is currently worth $280.83 per share, we could expect a 0.5297 move in the option for $1 move in SPY. But if the option subsequently becomes in the money, delta increases and could rise to 0.60, 0.70 or even 1.00 for a deep in the money call.
On the flip side, delta will fall as an option becomes out of the money or OTM. Using the same example, if SPY falls to $270, the $280 strike call may have a delta of 0.25 or much less. Delta works the same way for PUTS with a main difference that a PUT’s delta will always be negative. So if the stock price rises by $1, the negative put delta shows how much value we should expect the put to fall.
Delta grows bigger with in the money strikes. It is possible for Delta to become close to 1. This means that for every $1 move in the stock or ETF, the option will grow by $1 per share or $100 per contract. The further OTM a strike price is the smaller delta becomes. When an option is several strike prices OTM, delta can be as low as 0.01. This means for every $1 move in the stock or ETF, the option will grow by $0.01 or $1 per contract.
Gamma measures the rate of change in option’s Delta per $1 change in the stock or ETF price. Think of gamma as an accelerator. Going back to the delta explanation I did above, the 280 strike call had delta of 0.5297 .
Lets say SPY stock moves up by $1. This $1 move would cause a call option to be deeper in the money, and thus the delta will move closer to 1.00. Lets assume the Delta is now 0.5476. This change in delta from 0.5297 to 0.5476 is 0.0179 – which is the option’s gamma.
Gamma is highest for at the money or ATM calls and puts. It goes gradually lower as the calls and puts move further out of the money or OTM. All things equal, delta of an OTM option will change more than the delta of an OTM option when the underlying stock price changes.
Theta measures time value erosion. This if often called as time decay. Theta measures the change in the price of an option for a single day decrease in its time to expiration. Since options lose value as expiration approaches, theta can estimate how much value the option will lose, if all else remains the same.
In the case of the above SPY option chain, the option will lose $0.21 each day when all remains the same. In my upcoming posts I will show you how you can turn theta to your advantage by trading vertical spreads and Iron Condors.
The last important greek is Vega which measures sensitivity to volatility. Vega tells you the rate of change in an option’s price per 1% change in Implied Volatility of the underlying stock. A rise in Vega will typically cause both calls and puts to gain in value. Conversely, a drop in Vega will typically cause both calls and puts to lose value. For example, option price will move 0.2684 for per 1% change in IV of SPY.
Option Greeks Recap
|Greek||Dependent variable||independent variable|
|Delta||Option Price||Value of the underlying Stock|
|Gamma||Delta||Value of the underlying Stock|
|Theta||Option Price||Time to Expiration|
|Rho||Option Price||Interest Rate|
Now that you have been grounded with option greeks, you will find the Binomial Option Pricing in Excel quite easy to follow.