At some point in your options trading experiences, you’re likely to read or hear about “Greeks.”
You may think that someone is referring to what type of food they want for lunch. However, in options trading it has to do with indicators on options prices. This article will help you get up to speed with options Greeks.
Be forewarned, Greeks for options trading have much to do with those dreaded calculus classes you took in high school or college.
The good news is you won’t have to calculate anything yourself. Your trading platform does all the heavy lifting.
Understanding the Greeks can help you know whether you need them at all. Some diehard options investors swear that they are imperative to use. Most of these pretenders don’t know much about their meaning, however.
If you get nothing else out of this article, learn about the Greek indicator called delta. It’s a good one to start with, and if you understand what it tells you, learning the other indicators will fall into place more easily.
The main indicators used by most options investors are delta, gamma, vega, theta, and rho.
For simplicity, rho will be disregarded. It indicates the price of an option concerning a change in interest rates. Since interest rates don’t change that much, it won’t have too much of an impact.
If interest rates start to pick up steam in time, rho could become a consideration.
The main indicators
Delta is the change in price in an option for every unit of change in the underlying stock. Often, the unit is one dollar. When a stock increases (or decreases) by one dollar, the delta lets traders know how much the option will increase (or decrease).
Thus if the delta is 0.40, then a one-dollar increase in the stock price would lead to a 0.40 increase in a call option value. For put options, it would be a decrease.
In terms of calculus, the delta is the first derivative of the pricing model. The first derivative refers to the velocity of the change. A delta close to 1.00 will increase faster than a delta of 0.40. When dealing with put options, the deltas are negative.
Delta can be used to give an estimate of the probability the option will be in-the-money at expiration. This concept is only a ballpark figure, though.
Gamma is the rate of change of delta. It is the second derivative of the pricing model (that nasty calculus stuff). Active traders may get in and out of positions quickly, and gamma can help them decide the timing of these moves. For long-term options investors this indicator won’t be as useful, if at all.
Theta is the rate of decay. Options contracts are wasting assets, meaning their values will be zero at expiration. Theta is a measure of how quickly the option’s price will lose value for each day that passes.
Theta can be a useful measure to determine whether to close out a position if the expiration date is approaching quickly. For long-term options, however, theta doesn’t have as much predictive power.
Vega is a useful measure for active options traders. It measures how much an option price will change for each one-unit change in implied volatility. Implied volatility is a complicated topic, which can and does fill volumes of textbooks.
For this discussion, implied volatility is the difference in the price given the historical volatility.
Suppose you calculated the historical volatility using the standard deviation of a stock’s historical prices. Then, you plug that volatility calculation into an option pricing model to give you a theoretical price of the option. If the actual option price is different, the implied volatility explains the difference.
The biggest challenge associated with Greeks is they change constantly. Each increase in price leads to a recalculation of these measures. It is almost impossible to keep track of these indicators without the help of software.
Most options trading platforms provide this information to you as part of the service.