Notation is key in any profession, whether law, medicine, science or money, and somehow all of these fields have agreed that the best way to write down complicated ideas is with the Greek alphabet.
Lawyers use the Greek letter “pi” for plaintiff. Doctors use “alpha” to refer to chemical relationships, while scientists use “delta” to represent rates of change.
Investors do the same thing. When it comes to an investor’s Greeks, here are the five that you will need to know.
The most common Greek because it touches on the most common subject, Delta measures how much the value of an options contract changes based on the movement of its underlying asset.
See… the relationship is not 1-to-1.
Options contracts move based on the value of their underlying asset but they do not completely reflect it. Instead the price of an options contract reflects the value of the asset filtered by the extrinsic and intrinsic value calculations, or how traders believe the value of the asset will move relative to the strike price before the expiration date.
A $1 change in asset price gets filtered through all of those factors to determine how much the option price changes. The degree to which that $1 asset change influences the option price is the delta.
Okay, so here is the thing about an options premium: it is heavily based on the time until expiration.
The greater the time between purchase and expiration, the more uncertainty will exist in an option contract. This creates the extrinsic value.
Theta measures how that changes with each passing day. The closer an option gets to expiration, the less its value becomes (because uncertainty has gone down, so buyers and sellers can be more confident about what will happen on the expiration date). Theta measures how much an option’s value decreases as the contract gets closer to expiration.
Vega is a measure of how much an option’s price responds to implied volatility.
The implied volatility of an options contract reflects the degree to which volatility in the underlying asset will affect the market price of the option.
An option contract is priced based on two factors: intrinsic value, or the gap between the option’s strike price and the asset’s current value, and extrinsic value, the measure of volatility and everything else that can happen over time. The more volatility traders expect out of the asset, the higher they will set the premium.
This relationship between volatility and price is called implied volatility, and the degree to which a trader moves the price based on a measure of implied volatility is the vega.
The good news about gamma is that it is easier than vega!
Gamma measures how much delta changes based on movement in the underlying asset. This is less complicated than it seems.
Delta measures how much the price of an options contract will change given a change in the underlying asset’s value. However, at different prices the delta will be different. An options contract that is far out of the money will not respond much to changes in the asset value. The closer the asset gets to its strike price, though, the more the option price will reflect any changes and the bigger the delta.
How that delta value changes with each shift in the underlying asset is the gamma.
We will not touch extensively upon rho here because it is used infrequently, but it is a big enough deal to know the basics.
Rho is how an options contract price changes based on a shift in interest rates. It is worth mentioning because interest rates are one of the most important parts of the financial world. It is worth moving past quickly, however, because interest plays little role in pricing most options.
These are the five biggest Greeks! Understand them and you will soon find that options trading has become one step closer to second nature.
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