Understanding Option Greeks: Delta, Gamma, Theta, Vega, Rho
What Can Greek Options Do for You?
Armed with Greeks, an options trader 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).
What Are Greeks Anyway?
Greeks, including Delta, Gamma, Theta, Vega, and Rho, measure the different factors that affect the price of an option contract. They are calculated using a theoretical options pricing model. Since there are a variety of market factors that can affect the price of an option in some way, assuming all other factors remain unchanged, we can use these pricing models to calculate the Greeks and determine the impact of each factor when its value changes. For example, if we know that an option typically moves less than the underlying stock, we can use Delta to determine how much it is expected to move when the stock moves $1. If we know that an option loses value over time, we can use Theta to approximate how much value it loses each day.
Delta: The Edge Ratio
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 security or index. For example, a Delta of 0.40 means that the option’s price will theoretically move $0.40 for every $1 move in the price of the underlying stock or index.
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. Since a Delta is only good for a given moment, Gamma tells you how much the option’s Delta should change as the price of the underlying stock or index increases or decreases. If you remember high school physics class, you can think of Delta as speed and Gamma as acceleration.
Theta: Time Decay
Theta measures the change in the price of an option for a one-day decrease in its time to expiration. Simply put, Theta tells you how much the price of an option should decrease as the option nears expiration.
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. While Vega is not a real Greek letter, it tells you how much an option’s price should move when the volatility of the underlying security or index increases or decreases.
Rho: Sensitivity to Interest Rates
Rho measures the expected change in an option’s price per 1% change in interest rates. It tells you how much the price of an option should rise or fall if the “risk-free” (U.S. Treasury-bill)* interest rate increases or decreases.
Implied Volatility: Like a Greek
Though not a Greek, implied volatility is closely related. The implied volatility of an option is the theoretical volatility based on the option’s quoted price. The implied volatility of a stock is an estimate of how its price may change going forward. In other words, implied volatility is the estimated volatility of a stock that is implied by the prices of the options on that stock.