Option Greeks


Option Greeks is a difficult topic. Not because the concepts are difficult, but because people tend to either be scared of them and try and avoid thinking about them, or they get so bogged down in the mathematical modelling aspects that they end up with analysis paralysis and stop trading.

Let's keep it simple. Firstly, the Option Greeks are not scary spartans, but are just measuring tools, like inches, kilogrammes and mpg. Secondly, you don't always need to use all of them. The Greeks that you use depends entirely on the type of trading that you do. Thirdly, the Greeks are no more an exact science than any economic indicator. Therefore, you do not need to worry about the fourth decimal point. You need to be looking at broad trends, not minute details.

TOP TIP: Click here for a free 5 minute primer in Option Greeks

Changes in Option Value are measured by Six Option Greeks:

I will focus on five out of the six Option Greeks: Delta, Gamma, Theta, Vega and Zeta. The sixth, Rho, has almost no relevance for active traders.

Delta

DELTA measures the rate at which the price of the option changes with changes in the underlying stock (analagous to speed).

For example: If the DELTA of a call option is +50, then as the stock moves up $1.00, the option price will increase by approximately $0.50.
If the DELTA of a put option is -99, than as the stock moves down $1.00, the option price will increase by approximately $0.99.

Why is this important? When choosing options, you want to find those with a reasonably high delta, so that as the stock moves, the option will rapidly follow suit. If you trade DITM options, you maximise the leverage of DELTA. Or, you can choose to trade combinations of options that are called DELTA NEUTRAL. This means that you can balance your trades in such a way that DELTA is effectively zero, in which case you win whichever way the stock moves (these strategies tend to be low in profit, low in risk, but high in commissions).

Gamma

GAMMA measures that rate at which DELTA changes (analagous to acceleration).

GAMMA helps a trader measure risk, because a high Gamma means that an option's Delta is very sensitive to change. Gamma is always high when an option is ATM or NTM (near-the-money), and it is low for DITM or DOTM (Deep-Out-of-the-Money) options.

GAMMA is really only useful for those who trade Delta Neutral options - if Gamma is high, it means that the stability of your trade could change any time, and so you need to monitor your position closely.



Theta

THETA measures the rate at which the price of the option changes over time.

For example: If the THETA of an option is -0.50, then your option value will decrease by approximately $0.50 every day until the contract expires.

NOTE: The closer you are to expiration, the more the THETA grows - the price of the option decreases at an increasing rate over time.

Why is this important? If you BUY calls or puts, THETA or TIME DECAY becomes your enemy. If THETA is high, you must plan to not hold on to the option for too long! TIME DECAY will eat up the profits made from an increase in the stock price.

If you SELL calls, puts or credit spreads, you simply have to hold on to the option, watching as its value decreases every day until it expires worthless (unless it is ITM), at which point you pocket your profits and do it again! Selling Options with high Theta means that you will be able to watch the value of an option decrease rapidly, and become almost valueless, at which point you can buy the option back for next to nothing, and sell another one. You can see how I do this regularly on my Credit Spreads page.


Time Value can be your ENEMY and EAT your profits;
It can be your FRIEND and earn your profits!


Vega and Zeta

VEGA and ZETA are two indicators that measure the change in an options value relative to changes in Volatility. VEGA measure the effect of changes in Historical Volatility, and ZETA measure the effect of changes in Implied Volatility. In both cases, higher volatility means higher options premiums, and therefore potentially more profit; it also means more risk!

Historical Volatility (measured by VEGA) is a statistical measure of how volatile the stock has been in recent history. Options with high Vega have experienced high volatility, and therefore could change price rapidly as the stock price changes. High Vega options are more expensive; low Vega options are cheaper. VEGA is derived from underlying stock price movement.

Implied Volatility (measured by ZETA) is a measure of the theoretical current value of an option. Using historical volatility, Theta, stock price, option premium and a few other factors, and theoretical value for Zeta is calculated. Zeta is derived primarily from market premium of the option itself.

When Vega and Zeta are positive, increased volatility is helping an option position by increasing its value; when they are negative, increased volatility is hurting the option position (if you are buying calls and puts).

When Zeta is higher than Vega (i.e. Implied Volatility is higher than Historical Volatility), options prices could be overvalued, and this is a good time to Sell Options.
When Vega is higher than Zeta, options prices could be undervalued, which may be a good time to Buy Options. NOTE: it does not always follow that undervalued options will suddenly increase in value; they may stay undervalued for their whole life span!).

And that is the Option Greeks!

Here is a detailed video on Stock Option Greeks:

 

 

My favourite strategy? I love selling options for high priced stocks with high volatility and high Theta. They sell for a good price, they quickly lose value, and they are nicely profitable. I will often sell a nice expensive, volatile option three days from expiration. The only really important issue is that you know what the trend of the stock and the market are doing.

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  • On this page you will learn the about the way changes in options prices are measured. Yes, this is the dreaded subjects of Option Greeks! No, not the heros who crossed the Alps on elephants, nor the 300 brave fellows who dealt a blow to the Babylonians. These are just 6 Greek letters that look scarier than they really are.

    Don't be intimidated. You do not need to be a mathematical genius. Just get a grasp of the concepts! Look for patterns; take a big picture view.


    Looking for some further study on option greeks? Here is my top pick:


    Trading Pro System

    An outstanding Options Trading Course that I recommend. The follow up course is even better!