What Are Options Greeks And How Do They Work in Options Trading?
Options Greeks - Definition
Options Greeks are a set of mathematical variables which define the factors that influence the pricing of an option through the Black-Scholes Options Pricing Model.
Options Greeks - Introduction
Options Greeks as a whole is one of the most complex topics that options trading beginners face early in their options education. A comprehensive and thorough understanding of the options greeks is essential to understanding how and why options prices behave the way they do. Such an understanding is essential for understanding and executing complex options strategies as well as to better enhance an options trader's overall trading results. This free options trading tutorial shall go into what options greeks are, what each of the options greeks do and how you can use them to better your trading results.
What Exactly are Options Greeks?
Options Greeks are simply a set of mathematical variables named using greek alphabets. They represent each of the major factors influencing the price of an option and are used in options pricing models such as the Black-Scholes Model in order to arrive at the theoretical value of an option. However, individually, Options Greeks are used by almost every options trader as a reference to better understand how their options strategies or portfolio might perform under various price outcomes and come up with hedging or adjustment strategies should it be necessary. This made understanding options greeks something all options traders should achieve before trading options for real. There are 5 main Options Greeks; Delta, Gamma, Theta, Vega and Rho.
Options Greeks: Price Change Indicators
Options Greeks are basically "Price Change Indicators" that give you an idea how the price of an option could change if each of the 5 main factors represented by the options greeks changes. However, one needs to note that in reality, options prices do not move exactly dollar for dollar, cent for cent, how the options greeks predict it to due to two main reasons; Firstly, options prices are also affected by demand / supply and how heavily the option is traded. Secondly, options greeks do change as options prices change and therefore represent only a snapshot in time rather than how the price of an option would actually change over time. As such, options traders referring to options greeks individually for reference only do so in order to have an idea how their options position may behave rather than to use each of the options greeks individually in precise calculation for potential profit and loss. Lets take a look at what are these five options greeks are and the five main pricing factors that they represent.
Delta
Delta is probably the most important of the five options greeks due to the fact that it generally has the biggest impact on the price of an option. Delta measures how much the price of an option is expected to change with every dollar change in the price of the underlying stock. For instance, a call option with a delta of 0.7 can be expected to rise by $0.70 with every $1.00 rise in price of its underlying stock and a put options with a delta of -0.7 can be expected to appreciate by $0.70 with every $1.00 drop in price of its underlying stock. This information allows an option trader to predict in an informed manner the profit that might be achieved with every dollar rise or fall of the underlying stock right from the start and also allows a hedger (read about the different kinds of options traders) to design Delta Neutral Positions. Read more about Options Delta.
Theta
Theta measures one of the scariest aspects of options trading; Time Decay. Theta measures how much the price of an option is expected to decline every calendar day even if the price of the underlying stock remains stagnant. For instance, an option with a theta of -0.20 means it is expected to lose $0.20 everyday with all other factors unchanged. Of course, it is almost impossible for all other factors to remain unchanged, that's why it is not always possible to see the direct effect of time decay as predicted by theta on your options positions. This information allows position traders trading credit spreads that profit mainly from time decay to predict reasonably how long it would take for their positions to achieve breakeven. Read more about Options Theta.
Vega
Options Vega measures how the price of an option change with changes in volatility of the underlying stock. Volatility is a pricing consideration in options trading because the more volatile the underlying stock is expected to be, the greater the chance of an options going in the money profitably. This makes an option written on a more volatile stock more valuable than an option written on a less volatile stock and this is expressed mathematically in the Vega variable. An option with vega of 0.02 is expected to rise by $0.02 with every point rise in implied volatility. Vega allows an options trader to understand how their position would behave particularly leading up to volatile events such as an earnings release. Such an event can cause implied volatility to rise leading up to the event which can be taken advantage of profitably using Delta Neutral Strategies. Read more about Options Vega.
Rho
Options Rho measures how the price of an option change with changes in risk free interest rate, mainly tagged to short term bond rates. Rho is a somewhat negligible options greek due to the very small effect (somewhat negligible) that interest rates has on options pricing. However negligible, this factor is promptly and scientifically incorporated into an options pricing model as Rho. Read more about Options Rho.
How Does Knowing Greeks Help One Trade Options Better?
Apart from being able to gauge potential profits upfront and being able to structure options strategies that serve specific trading objectives, knowing about options greeks actually help options traders trade better by helping them identify potential areas of risk that may not be obvious from the primary nature of the options strategy being used. For example, you may not be aware of the effect of time decay on a directional strategy such as the Bull Call Spread until you see that it actually has significant negative theta from the options greeks. This information alerts you to factor that into your risk assessment of the strategy and therefore trade better.
Where to Get Options Greeks?
Options greeks can be obtained from options chains known as "Pricers". Options pricers typically display all the options greeks of each and every options contract just like in the picture below:
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