The short version
- Options Greeks help you make a reasonable assessment of the risks associated with any options contract taken.
- There are five main option Greeks, each measuring risk from a different angle. Together, they can provide a more comprehensive look at the risk associated with any options contract.
- Option Greeks are commonly available with options trading software, offered by major investment brokers and third party services.
What are options contracts?
Options contracts are agreements that give the holder the option to either buy or sell a specific security. An option contract can be used to gain the right to buy or sell stocks, stock indexes, exchange traded funds (ETFs), bonds and other fixed income assets, currencies, or commodities.
Each option has:
- An expiration date
- A premium, which is the cost or value of the option,
- A strike price, which is the target price the option holder is hoping the security will reach.
There are two types of options: Call options and Put options.
A call option gives the holder the right to buy a security, while a put option allows the holder to sell it. In either case, the holder does not need to own the underlying security at the time the option contract is written.
More: What is options trading?
Let’s say you execute a call option contract to purchase 100 shares of a stock at $50 (the strike price) in 90 days (the expiration date) at a cost of $1 (the premium).
If the stock price rises to $60 on or before the expiration date, you can exercise your option to purchase 100 shares at $50 each, or $5,000. You can then immediately sell the newly acquired shares at $60, or $6,000.
Your net profit on the trade will be $900: That’s the $6,000 sale price, less the $5,000 acquisition cost plus the $100 (100 shares X $1) for the option premium.
On the flip side, if the share price never rises above $50 during the 90-day option term, you can simply allow the option to expire. Should that happen, your loss will be limited to the $100 paid for the premium.
A put option works in the opposite direction. It’s an option contract designed to give the holder a profit based on a decline in the value of the underlying security. In this way, put options are very similar to short sales.
Continuing the example of the call option above, under a put option you might write a contract with the same security trading at $50, but with the expectation that the value will drop to $40.
You’ll execute a put option contract to sell 100 shares of the stock at $40, within 90 days, at a premium of $1 per share.
If within the 90 days, the stock price falls to $40, you can exercise your option to sell 100 shares of the stock. If you do, you would make a $1,000 gain on the transaction (less $100 for the premium paid).
In this way, options give investors the ability to make large gains on very small investments, and with very limited losses.
What are Options Greeks?
Options Greeks are measures of anticipated price changes of an option. They can be used to measure an individual option, or a portfolio of option contracts. There are five main Greeks:
In addition to these five main options Greeks, there are also less popular measures often referred to as minor Greeks. They include color, epsilon, lambda, speed, ultima, vamma, vera, and zomma.
What do they do?
Each of the five main Greeks attempt to measure a different factor that influences the anticipated value and direction of the underlying security in an option contract.
Perhaps most important measure is volatility. That’s how much the value of the underlying security is likely to change within a certain expiration period. That can be affected by economic forces like changes in interest rates, changes in the company’s financial condition, and the expected direction of the financial markets.
More: Best defensive investments to survive bear markets and high volatitlity
When it comes to options, there are two primary types of volatility: implied volatility and historical volatility.
is the market anticipation of the likelihood that the price of the underlying security will change.
is the measure of the change in price of the underlying security over a specific amount of time. Put simply, historical volatility looks at how often a security varies in price from its average price, and to what degree.
Both types of volatility must be considered when investing in options, because volatility is a huge influence of risk with the option.
The option Greeks attempt to provide different ways to measure volatility (and value) of an option based on its expected performance.
The five options Greeks
Each Greek measures volatility from a different angle. Theoretically at least, the use of multiple Greeks should provide a relatively accurate measure of the volatility of the security. They should help reduce the risk and increase the probability of a profit on the contract.
Here are the most popular Options Greeks.
Delta helps you determine if an option will expire “in the money” (ITM), and if so, by how much. For calls, that means the strike price is below the underlying security’s market price. With puts, it means it’s above the market price.
More specifically, Delta is a measure of how much an option price can be expected to move for every $1 change in the underlying value of the security. If, for example, the Delta of the position is 0.50, the option price is expected to move $.50 for every $1 change in the security price. We can think of it as something like a beta for stocks.
For call options, there is a positive Delta, which ranges between zero and 1.00. The option price will get closer to 1 as it gets deeper In the Money (ITM) and as the expiration approaches. Out of the Money (OTM) call options will have Delta values that get closer to zero as the expiration approaches.
For put options, there’s a negative Delta, ranging between zero and -1.00. Delta will be near -0.50 for at-the-money (ATM), but move toward -1.00 as the option gets closer to ITM or as expiration approaches. OTM on put options will approach zero as expiration approaches.
Gamma measures the rate of change in Delta over time.
If an option has a Delta of 0.50, it should move by $.50 for each dollar. But as it does, the Delta will increase toward 1.00. If it rises to 0.60, the Gamma for the option may be, say, 0.15. And because Delta can never be greater than 1.00, the rate of Gamma decreases as the option price moves closer to ITM.
This is a measure telling you how much the price of an option will decrease each day as it approaches expiration. The process is also known as “time decay”.
Theta increases for ATM, slightly as OTM and ITM approach, but typically decreases as expiration approaches with far OTM options (“far OTM”, which refers to a big difference between strike price and underlying price).
Vega measures the rate of change in an option price in the implied volatility of the underlying security (per percentage point). Volatility is a crucial factor affecting option values.
A decrease in Vega will usually cause calls to lose value, while an increase will cause a gain in value. You should consider buying options when Vega is below normal levels and selling them when they move above normal. Given that volatility is a crucial factor affecting option values, Vega should never be ignored.
You may be able to tell if Vega is above or below normal by comparing the historical volatility of an underlying security to the implied volatility.
Rho indicates how much the price of the option will rise or fall based on changes in rates on U.S. Treasury securities.
This Greek measures the expected change in an option price per percentage point change in interest rates, an important factor in today’s environment of Federal Reserve rate increases.
Call options are said to have positive Rho, because the value of these options will generally increase with a rise in interest rates. Put options are said to have negative Rho, because the value of these options will usually fall when interest rates decline.
More: How to invest for rising interest rates | Best stocks and sectors
How to make the best use of options Greeks
If trying to figure out the Options Greeks is all Greek to you, don’t sweat it. Fortunately, many large brokerage firms offer software that will let you painlessly call upon the Greeks when trading options.
And if the software is available to you, you should take full advantage of it — most seasoned options traders do. Trading options, like investing in individual stocks, requires a large dose of upfront analysis. But it also takes ongoing analysis to know what to do with a contract.
Options Greeks are all about measuring the risk involved in options contracts, relative to different variables. They won’t completely eliminate the risk associated with options trading, but they can help you to identify the more obvious ones. And at a minimum, they’ll help you to know exactly how much risk you’ll be taking on with any contract.
Ultimately, options trades are all about profitability, and profitability depends largely on risk analysis. That’s the job of option Greeks, and you should become familiar with them as you hone your skills as an options trader.
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