The Greeks are the measures of individual risks associated with trading options, so called because each one is identified by a Greek letter.
They’re quite technical – but understanding their essential principles will help you see the risks of particular options. The main Greeks we’ll be using are:
Delta – the ratio that compares the change in the price of an asset to the corresponding change in the price of its option.
It shows how much an option’s price moves for every point of movement in the underlying asset. So delta is a measure of how movement in the underlying market will impact the price of your option, otherwise known as directional risk.
More simply, delta tells you how likely the option is to expire with any value.
Delta is often used in hedging strategies and is also referred to as the hedge ratio.
Delta values can be positive or negative. The delta for a call option always ranges from 0 to 1, because as the underlying asset increases in price, call options increase in price. Put option deltas always range from -1 to 0, because as the underlying security increases, the value of put options decreases.
In-the-money call options get closer to 1 as their expiry approaches. At-the-money call options typically have a delta of 0.5, and the delta of out-of-the-money call options approaches 0 as expiry nears. The deeper in the money the call option, the closer the delta will be to 1, and the more the option will behave like the underlying asset.
Example
Say you have a stock call option with a delta value of 0.75. If the underlying stock increases in price by $1 per share, the option price will rise by 0.75 per share.
Vega – how much an option’s price moves when the volatility of the underlying asset changes. Vega represents the amount that an option contract’s price changes in reaction to a 1% change in the implied volatility of the underlying asset. Vega changes when there are large price movements (increased volatility) in the underlying asset, and falls as the option approaches expiry.
When you own options, you have a positive vega, whereas writing options carries a negative vega.
Example
Say you have an option with a vega of two. It will move two points when its underlying market’s implied volatility changes by 1%
Theta – how much an option’s price declines over time. It can also be referred to as an option’s time decay. An option generally loses value as time moves closer to the maturity of the option. Theta is a negative number and can be thought of as the amount by which an option’s value will decline every day.
An option with high theta (usually one with a short-term expiry) will rapidly depreciate in value as it nears expiry.
Example
Say you have a long option with a theta of -0.50. The option’s price would decrease by 0.50 every day that passes. Note that this theta is an ever-changing number – as we approach expiry it becomes increasingly negative, with time value decaying at a faster rate as expiry nears.
Lesson summary
- Delta is a measure of the change in an option’s price or premium resulting from a change in the underlying asset
- Vega measures the risk of changes in implied volatility or the forward-looking expected volatility of the underlying asset price
- Theta measures how much an option’s price declines over time, or its time decay