Trying to predict how an option will react to the underlying stock is not something you can eyeball.

To the untrained eye, options prices seem to be erratic and illogical.

No wonder so many traders swear options off just after a few losses.  

The hardest concept to understand early on is that option prices do not move step-by-step with the price of the underlying asset.

And that is why it is important to understand exactly what factors contribute to the movement of option prices.

Options traders often refer to delta, gamma, vega, and theta of their options positions as “Greeks.”  

These values assist a trader so they can understand the sensitivity of an option’s price to various conditions.  

These terms may seem confusing, but broken down, the Greeks are quite simple to understand.  

Greeks refer to simple concepts that can help you better understand the risk and potential reward of an option position.

 

The Greeks

 

It’s important to understand that the numbers calculated for the Greeks are based on mathematical models.

Most of the information you need to trade options, such as, bid, ask, last price, volume, and open interest is all data received from the options exchanges.  This options data is received and distributed by your data service or brokerage firm.

The Greeks need to be calculated and their accuracy is only as good as the model used to compute them.  

When looking to understand Greeks for the first time it is easiest to think about the impact each value has on the price of an option assuming all other factors remain unchanged.

 

What Can Option Greeks Do For You?

 

Greeks are a powerful tool for options traders… especially for traders looking to make decisions based on these values, such as, selling options and short volatility strategies

An option trader can get a high level overview of what option to trade just by looking over the Greeks.  This will allow them to make a more informed decision about which option to trade and when to trade them.

Here are some examples of how the Greeks may help you:

  • Delta – Assists the trader to gauge the likelihood that an option will expire in the money.  This also is used to determine how much an option price is expected to move when the underlying moves $1
  • Gamma – This estimates how much the Delta will change when the stock price changes
  • Theta – This estimates how much value your option should lose each day as it approaches expiration
  • Vega – The measure of how sensitive the option price is to volatility or large price swings in the underlying stock.

Let’s go into each of these with greater detail…

 

Delta: The Hedge Ratio

 

Call Options

  • Values for Delta are positive and range from 0.00 to 1.00
  • At-the-money options have a Delta near 0.50
  • Delta will increase and approach 1.00 as the option gets deeper in the money
  • Delta of in the money options will continue to have increasing values approaching 1.00 as expiration nears
  • Delta of out of the money options will continue to have decreasing values approaching 0.00 as expiration nears

Put Options

  • Values for Delta are negative and range from 0.00 to -1.00
  • At-the-money options have a Delta near -0.50
  • Delta will decrease and approach -1.00 as the options get deeper in the money
  • Delta of out of the money put options will get closer to 0.00 as expiration approaches

Delta is the probability that a given option will expire in the money.  

For example, a Delta of 0.40 means that an option has about a 40% chance of being in the money at expiration.  

Delta also gives the trader an estimation of the price movement of options per dollar of underlying stock.  

For example, a Delta of 0.40 means that given a $1.00 move in the underlying stock, the option will gain or lose $0.40 of value per $1.00 move in the underlying.  

 

Gamma:  The Rate of Change of Delta

 

Gamma measures the rate of change in an option’s Delta per $1 change in the price of the underlying stock.  

Gamma tells you how much the options Delta should change as the price of the underlying stock or index increases or decreases.  

Make sense?

If not, think of Delta as the speed of the car and Gamma as the Acceleration of the car.

For example, assume an option has a Delta of 0.40 and a Gamma is 0.15.  If the stock moved $1.00, the Delta would change to 0.55 and force the value of the option to move $0.55 instead of $0.40.  

This change in speed is due to Gamma.

Note:  Because Delta cannot exceed 1.00, Gamma decreases as an option gets further in the money as Delta approaches 1.00.

 

Theta: Time Decay

 

Theta measures the change in the price of an option for one ay decrease in time to expiration.  

Theta simply tells you how much the price of an option should decrease as the options near expiration.  

Because time value is not linear, Theta that is at the money, out of the money, and in the money generally increases as expiration approaches.  Theta of far out of the money options generally decrease exponentially as expiration approaches.

Note:  Theta never increases the value of an option like other Greeks would do.

Vega: Sensitivity to Volatility

 

Vega measures the rate of change in an option’s price per 1% change in the Implied Volatility of the underlying stock.  

Vega is meant to give you an indication of how much an option’s price should move when the volatility of the underlying security increases or decreases.

Key points about Vega:

  • Vega measures how the implied volatility of a stock impacts the price of an option
  • Volatility is one of the most important factors affecting the value of options
  • Drop-in Vega will cause both calls and puts to lose value
  • Increase in Vega will cause both calls and puts to gain value

Vega:  Implied Volatility

 

Implied Volatility of an option is the volatility based on the option’s quoted price.  This is an estimate of how the options price my change going forward.  

In other words, implied volatility is the estimated volatility of a stock that is implied by the price of the options on that stock.

It’s also good to remember that unlike other Greeks, volatility is a calculated value based on a complex options pricing model.

Key points about Vega:

  • Implied volatility is calculated based on historical volatility.  
  • Higher than average implied volatility is usually more favorable for option sellers
  • Lower than average implied volatility is usually more favorable for option buyers
  • Volatility is a mean-reverting instrument
  • Implied Volatility is not consistent for all options and is lower for at the money options

Pro Tip: Since it’s difficult to estimate how volatile a stock really is, you can watch implied volatility to know what is being priced in by the market makers.  

 

Wrapping Up:

 

Trying to predict what will happen to the price of a stock is hard to do…. And trying to predict the price of a single option or complex position with multiple options can be an extremely difficult task.

The largest problem with new options traders is that prices do not appear to move step-by-step with the price of the underlying asset.

And that is why it is important to understand exactly what factors contribute to the movement of option prices.

These concepts may seem confusing and intimidating to new option traders, but with the help of the pros, you can learn them in hardly any time!

If you’d like how I put this all into action, check out this training I put together.

Author: Dave Lukas

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