To be a successful option trader, an investor naturally has to pay attention to the prices of options. It is not enough to merely watch the option prices, selling when the price is up and buying when the price is down. Informed options investors will study and analyze their positions based on the Greeks. The Greeks are the indicators of how an option moves based on the outside components of the option.
Delta…
Delta is a measure of the sensitivity the option value has to changes in the underlying equity price. A call option with a Delta of 0.5 will gain $0.50 in value if the stock gains a point. Conversely, the call option would lose $0.50 in value if the stock dropped a point. Puts have negative Delta’s because they lose value when the stock rises, and gain in value when the stock falls. At-the-Money (ATM) options will have a Delta of about 0.5. Deep In-the-Money (ITM) options will have higher Delta’s (higher negative values in the case of puts) and deep Out-of-the-Money (OTM) options will have lower Delta’s (lower negative values in the case of puts). Both option buyers and option sellers need to be aware of Delta so they can estimate how the option price will change as the underlying gains or loses in value. Delta becomes especially important in spread trading, particularly in Calendar and Diagonal spreads, and many investors will trade Delta neutral strategies.
Gamma…
Gamma is the rate that the options’ Delta changes as the price of the underlying security changes. In the simplest terms, Gamma is the Delta of the Delta. Using the example above, if our call option has a Gamma of 0.02 and a Delta of 0.5, if the stock moves up one point the option will gain $0.50 in value. The Delta will now be 0.52 since it is now deeper ITM. If the stock moves up another point, our option will gain $0.52, and the Delta and Gamma will adjust in kind. As with Delta, there are strategies that an investor can employ using Gamma. These strategies are referred to as Gamma Trading.
Theta…
Theta is the rate at which an option loses value as time passes. Theta is the Time Value decay factor. An option with a theta of $0.04 will lose $0.04 of value with every passing day (assuming the stock stays stagnant). Theta is used often as a comparison when deciding which options to buy or sell. Option buyers will try to look for a lower Theta hoping that their investment does not lose too much value on a daily basis. Option sellers will look for a higher theta as they want the premium to decrease faster, thus they can buy it back sooner for a cheaper cost.
Vega…
Vega, sometimes referred to as Kappa, is the sensitivity of an options theoretical value to a change in volatility. An option with a Vega of 0.13 will gain $0.13 with a percentage point increase in volatility. As an example, if the value of the option is $3.50 at a volatility of 30%, then it will have a theoretical value of $3.63 at a volatility of 31% and a value of $3.37 at a volatility of 29%. If you are anticipating large volatility swings in an underlying security, paying attention to Vega’s can greatly help you increase profits or avoid major losses.
Rho…
Rho is the sensitivity of an options price to a change in interest rates. Call options will generally increase in value when the interest rate increases, since it raised the cost of carrying the options. Put options will decrease in value. Option price sensitivity to interest rates is low for short term and higher for the longer-term options. The greater the options’ expiration time frame, the greater the Rho.
Beta…
Beta is an important Greek for options investing, but it does not relate directly to the options price movements. Beta is the measure of the underlying security’s price sensitivity to changes in the market. The beta of the S&P 500 is 1, a stock with a beta of 1 could be expected to move with the same volatility as the S&P 500 average. A stock with a beta less than 1 will rise and fall more slowly in comparison to the S&P; while conversely a stock with a beta greater than 1 will be more volatile in comparison to the S&P 500. Negative betas are rare, but they can occur. Stocks with a negative beta indicate an inverse movement relative to the S&P 500. These negative beta stocks could be used as a market hedge by investors.
Knowing the Greeks and applying them to your options investing strategies can greatly help your performance. You can see all of the Greek data for any option (over 170,000) using the tools on PowerOptions. Using the patented SmartSearchXL tool you can search by the Greeks in any options strategy, plus sort the results by the Greek values from highest to lowest or lowest to highest.
[tags]options investing, option greeks, beta, gamma, rho, vega, delta, theta[/tags]