Speak Greek? How the Greeks Apply to Options Trading
Do you know and understand what the Greeks are and how they influence your options trading? Options trading is more difficult than stock trading because it is immensely more complicated. In stock trading, investors simply need to decide whether the equity is going higher or lower.
It’s a totally different game with options. In its simplest form, we need to decide on the price outcome (either up or down), how large the move will be and how long it will take. Like stocks, the first decision is a bullish or bearish. Even when we get the direction right, we can end up with a total loss on the trade if we fail to correctly estimate the other two factors. That’s where the Greeks come into play. We have four main Greek components: delta, gamma, theta and vega.
The Greeks: Delta
Simply put, delta measures how much the option price will change for each $1 increase in the underlying asset. Its figure stands between -1 and 1. Some prefer to look at Delta on a higher scale, between -100 and 100, but the point is still the same.
If we see a call option that has a delta of .38 (or 38), it means the call will increase by $38 should the underlying stock increase by a dollar. For a put, we see the opposite. If we have a delta of -0.4 (or -40), the put will lose $40 for each $1 increase in the stock price.
There are a lot of factors in determining the delta. The most important is how far in- or out-the-money it is. A deep in-the-money (ITM) call will likely have a very high delta. It’s possible for it to even equal 100, meaning the call mirrors the stock price step-for-step. A lack of liquidity can impact the day-to-day trading of a deep ITM option, but theoretically, this pricing dynamic is true.
The further out-the-money (OTM) the call is, the lower the delta will read. An out-the-money call with very little time remaining until expiration could command a delta of 10 or less.
The Greeks: Gamma
It’s harder to go into much more detail about delta without talking about gamma. Delta tells us how much the option moves for each increase in the stock price, right? Well, the gamma tells us how much the delta will change for each $1 change in the stock. That’s because the delta does not stay constant. As the stock price changes, an option becomes further in- or out-the-money and therefore our delta is different.
Gamma is always a positive number. Rather than being its largest when its deep ITM and smallest when it’s deep OTM (like delta), gamma is actually its largest at-the-money (ATM).
Why? Look at it this way. If the option is already deep ITM, even on big swings in the underlying stock, the delta doesn’t have much room to go. A 5% drop or 5% rally in the stock may be meaningless to a deep ITM option. The delta might go from 93 to 89, or from 93 to 95. But that’s a very small move. As such, the gamma is very small as well.
Similarly, think about a deep OTM position. If we have a $45 put on a $60 stock, a 5% drop isn’t enough to make our position meaningfully more valuable. As a result, the delta might go from 4 to 7, or some other minute increase. Again, that makes our gamma quite small, given the small move in the delta.
Now think of an ATM put. If shares fall 5%, that ATM put just went decently ITM and thus, its delta is going to spike, say from 40 to 75, depending on how much time is left until expiration.
In a nutshell, delta measures how much the option will change for a $1 increase in the price. Gamma tells us how much the delta will change in that move.
The Greeks: Theta
As expiration ticks closer, options lose their time value. This process is known as time decay and the measurement of that decay is known as theta. We all know options are made up of intrinsic value (how much they’re worth should they expire today) and time value (how much of its value exists due to potential).
For instance, I have a $45 put trading for $2.00 that expires in 20 days and the underlying stock is trading at $44. In this case, I have $1.00 of intrinsic value ($45 put – $44 stock price = $1.00) and $1.00 in time value (option value ($2.00) – intrinsic value ($1.00) = $1.00).
Likewise, let’s say the underlying security was trading for $45, I owned the $45 put and its premium is $1.50. I have no intrinsic value in the trade and therefore the entire $1.50 premium is composed of time value.
Theta measures how much the option position will decrease in value for each day of expiration that goes by. If expiration is quite a ways out, theta will be small, as it will take time to bleed the option out of value. The closer the option is to expiration, the faster its time will decay and eat away any non-intrinsic value. Theta is larger for ATM options vs. ITM or OTM. That’s because ATM options have the most time value compared to ITM or OTM positions.
The Greeks: Vega
Vega is a complicated measure and it’s not measuring the volatility of the option. Instead, it’s measuring the impact of volatility on the option. As volatility increases, it makes the prices of an option (both calls and puts) more expensive. As volatility decreases, it will sap value out of the options’ premium.
That’s why Option Party’s implied volatility tool is so useful to traders. It can help them track down trade setups that are have temporarily overvalued these options because of a spike in volatility. By selling over-inflated options, the trader can profit from a decrease in volatility, even if the stock price doesn’t move much. As volatility comes down, so too do the option premiums.
In any regard, we can’t use an instrument like the VIX to measures volatility. Vega is based on the volatility of each underlying security. No two stocks will be the same. As volatility shifts, so too does the vega measurement. Because increasing volatility and decreasing volatility impact an option’s price differently, it’s constantly being adjusted.
In fact, all of the Greeks are constantly changing and being calculated, because the measurements they’re based on — time, price, volatility — are also on the move. That’s why it’s always important to keep an eye on all of them.
The Bottom Line
The Greeks are anything but simple. But now we know what each measurement is and why it’s important to our option price.
For instance, if a company suddenly pre-announces worse-than-expected earnings (an unexpected event), its stock will fall. If we have an ATM put, it’s now ITM and its delta will fly higher. So will its vega, as this unexpected drop catapults volatility higher. Gamma and theta will drop as the option moves further away from ATM.