The “Greeks”
Whether you’re a beginner or already an seasoned options trader, you may have heard about the “Greeks” but you may not know exactly what they are or what they can do for you. If so, read on as I explain what these “Greeks” mean and how to use them to better understand the price of an option.
Option prices can change due to directional price shifts in the underlying stock, changes in the implied volatility, time decay, and even changes in interest rates. Understanding an option’s sensitivity to these various factors is not only helpful — it can be the difference between making money and losing money. It’s according to your own strategy to determine whether you’ll use them or not.
I’ll be perfectly honest, I know and understand the “Greeks” but I do not use them with each trade I make. After explaining what option “Greeks” can do for you, I’ll tell you why I don’t use them with each trade. If you’re a beginner and never heard of the “Greeks”, don’t let this subject matter intimidate or discourage you, but you must read and understand the concept of what the “Greeks” do.
If you arm your arsenal with the “Greeks”, as an options trader, you can make more informed decisions about which options to trade, and when to trade them. Consider some of the things Greeks may help you do:
- Gauge the likelihood that an option you’re considering will expire In-the-Money (Delta).
- Estimate how much the Delta will change when the stock price changes (Gamma).
- Get a feel for how much value your option might lose each day as it approaches expiration (Theta).
- Understand how sensitive an option might be to large price swings in the underlying stock (Vega).
- Simulate the effect of interest rate changes on an option (Rho).
I’ve been trading a long time. I’ve looked at tens of thousands of options, option chains, stock prices and their premiums at many, many expiration dates. At this point, with exception of Rho, I can look at a stock price, the expiration date and the premium and I can tell how a move in a stock will affect the value of the premium. Since I only do very short options (one or two weeks) I know how fast the time value will decay (Theta). In the last few week of an option, the time value decays at warp speed. I do not need to look at the Theta; because of the years of experience I can tell by the size of the premium the chances a stock will hit the strike price or go in the money. I know how high volatility will affect the premium if a stock is making huge moves. For these reasons I don’t use the “Greeks” so often. I feel like I have the “Greeks in my head. Read about them, know what they can do for you and make your decision if you’re going to arm yourself with a little more fire power of knowledge.
Delta
The first Greek is Delta, which measures how much an option’s price is expected to change per $1 change in the price of the underlying stock. For example, a Delta of 0.40 means that the option’s price will theoretically move 40¢ for every $1 move in the price of the underlying stock or index.
Gamma
Gamma measures the rate of change in an option’s Delta per $1 change in the price of the underlying stock. Since a Delta is only good for a given moment in time, Gamma tells you how much the option’s Delta should change as the price of the underlying stock moves up or down. If you remember high school physics class, you can think of Delta as speed and Gamma as acceleration.
Theta
One aspect of time-decay, which is often misunderstood and mismanaged, is the rate of time decay. “Theta” is the Greek symbol used to measure the relationship between time value and the time remaining to expiration. The rate an option losses time value is not consistent throughout its lifetime. As the option nears its expiration date, the rate of decay increases. In fact, during the last month prior to expiration there is a significant increase in the rate of time decay. Theta is a direct measure of time decay, giving us the dollar decay per day. Not to be redundant, but this amount increases rapidly, at least in terms of a percentage of the value of the option, as the option approaches expiration.
Vega
Vega is the option’s sensitivity to changes in implied volatility. A rise in implied volatility is a rise in option premiums, and so will increase the value of long calls and long puts. Vega increases with each expiration further out in time.
Rho
Rho is the option’s sensitivity to changes in interest rates. Most traders have little interest in this measurement. An increase in interest rates decreases an options value because it costs more to carry the position. I would say go with the feeling of most option traders and do not be concerned with Rho Grasshopper.