Options Greeks Definition - How to Calculate

Introduction

You may have heard of the option Greeks. However, they are not gods that options traders and investors worship. While options are derivatives of stocks, note that the Greeks explain the way these derivatives move. Did you know that the price of an option is usually influenced by numerous factors? These factors can either help or hurt you based on the positions you’ve taken in that option.

Keep in mind that factors, such as options premiums, option Greeks, and demand-supply of the markets tend to influence each other. While these factors and variables work independently, they are also linked to each other. You can see the final outcome of these factors in the option’s premium.

Are you trying to predict or anticipate what will happen to the value or price of one option or a position that involves multiple options? This can often be a difficult and tricky undertaking as the market changes. Remember that the option price doesn’t always seem to move in conjunction or accordance with the value of the underlying asset.

This is why you should understand what variables contribute to the change in the price of an option as well as the impact they have.

Sometimes, options traders and investors refer to the Gamma, Delta, Vega of their options positions. And these terms are collectively called the Greeks and offer a way to measure how sensitive an option's price is to quantifiable factors.

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If you are new to options trading, these terms might seem confusing and even intimidating to you. However, when broken down, the Greeks simply refer to basic concepts that will help you better understand and appreciate the risks and potential rewards of your option position.

Option Greeks Explained

Note that a Greek refers to one of many terms that traders use when evaluating risk and reward in option positions. And the Greeks, such as Gamma, work together in order to help option traders and investors make informed and reliable choices when managing their portfolios.

As a beginner options trader, you may avoid the Greeks, fearing that they are too complicated or math-heavy. The formulas used to calculate Greeks might seem complex; however, knowing them is not necessary to use option Greeks in trading.

You will be happy to know that nowadays software such as your broker’s trading platform and many calculators can easily do the calculations for you. However, your part is to know and understand what these Greek numbers mean and how they are related. You also need to understand how they can change or move under different circumstances.

In the world of options trading, Delta, Gamma, Vega, Theta, and Rho are called option Greeks. Did you know that the Greeks are important tools in risk management? They can help options traders make better decisions about when and what to trade.

Greeks help consider how different factors and variables like price changes, volatility, interest rate changes, and time impact the price of an option contract.

It is worth noting that each Greek, such as Theta, measures a different degree of risk. We can divide the Greeks into major and minor; however, major Greeks are used most often.

Delta

We can define Delta as an option Greek that measures the option’s price change that results from a change or fluctuation in the underlying asset or security. Keep in mind that the value of Delta is in the range of 0 to -1 for puts and between 1 and 0 for calls.

This means that call options have a positive Delta. So, if the price of the stock or asset increases, the price for the call will also go up, as long as other factors remain the same.

As you can see, at its most basic interpretation, Delta measures the value the option price may move based on a $1 fluctuation in the underlying asset or security. In other words, Delta measures how sensitive an option's theoretical value is to a change in the price or value of the underlying asset.

You probably know that with call options, asset prices and premiums move in tandem. So, if the price of the underlying security increases, the call premium increases too and vice versa. On the other hand, with put options, asset prices and premiums move in opposite directions. This means that if the price of the underlying security decreases, the put premium increases.

You can use Delta to gauge when an option contract is likely to be in the money (ITM) at the expiration date. And that is not all; you can also use Delta to balance risk and rewards. For example, a higher Delta usually means more risk but higher returns. In contrast, a lower delta can signal a lower risk but lower returns.

Gamma

We can define Gamma as an option Greek that is used to measure the rate of change (sensitivity) in an option’s Delta with regard to per unit change in the underlying asset or stock’s price. Gamma helps options traders understand and gauge what to expect, especially in the near future. 

Gamma is the Greek that gives you a better and more comprehensive understanding of how Delta will change or move when the underlying asset moves. For instance, if you have a long call option with a delta of 0.50 and Gamma of 0.10 and the underlying asset moves up $1.00, then the option will have a delta of about 0.60 if all else is equal.

You can use Gamma in order to measure the rate of fluctuation. This will allow you to get a reasonable idea of how volatile the Delta is before you invest. Did you know that values of Gamma are usually the lowest for people who find themselves either deep in or out of the money?

Also, Gamma will help you determine the likelihood or odds that an option will finally reach its strike price at the date of expiration, based on how stable or volatile the Delta is.

You should know that Gamma is often higher for option contracts that are close to being at the money. And as options gradually shift to being out of the money or in the money, Gamma becomes lower.

Keep in mind that Gamma is the friendliest to long option holders. This is because it increases profits for every $1 the underlying asset moves in your favor and decreases losses for every $1 the underlying asset moves against you.

Theta

Traders use Theta to measure how an option’s price or value erodes over time. Keep in mind that as an option gets closer to its date of expiration, erosion may happen more quickly. This is because the window for investors and traders to make a profit starts to shrink.

If you are new to options trading, Theta is one of the most crucial concepts to understand. This is because it explains the impact of time on the premium of the options sold or purchased. And the further out in time that you go, the smaller will be the time decay for an option.

This means that if you would like to own an option, it’s better to purchase longer-term contracts. And if your goal is to profit from time decay, it is best to short the shorter-term options so that the loss in value because of time happens quickly.

Time decay of an at-the-money call option

You should know that as you get closer to expiry (i.e., expiration date), the option premium will decline or decay quicker. And during the last thirty days leading to expiry, Theta will kick into overdrive. This is because the option’s premium decays the fastest during this period.

Also, time decay works for option sellers and against option buyers. This means that traders who purchase calls or puts need the underlying asset to go higher than the call strike or lower than the put strike before the expiration date. Otherwise, the options will expire worthless.

When you buy an option, the countdown to expiration starts and, so does a decline in the value of the option. If you are purchasing options, you may use Theta in order to decide when to exercise your option or whether you should do it at all.

Vega

There is another important option Greek. Vega allows traders to measure changes between option values and the implied volatility linked with the underlying security or asset. Keep in mind that implied volatility indicates how likely a security or asset will experience volatility in the future.

And when you perceive an option as being more prone to volatility, this generally translates to considerably higher premiums.

The Vega of your option informs you how much the option price would increase when volatility increases by 1%. This is important as it allows you to make predictions regarding how much the option value or price would change as volatility changes.

And it is worth noting that Vega can shift on the basis of changes in implied volatility alone and not any change to the price of the underlying security or asset. Also, the closer your option gets to the expiration date, the more Vega declines.

Vega against Stock Price

Rho

Rho measures how sensitive an option is to changes or fluctuations in interest rates. Specifically, Rho measures the rate of change between an option’s value and a 1% shift in interest rates.

Did you know that long puts and short calls have negative Rho? This means that the option price or value will increase when there is a decrease in interest rates.

And when interest rates rise, call options typically see their value increase. On the other hand, put options often decrease in value. This means that Rho is negative for put options and positive for call options.

Keep in mind that out of all options Greeks, Rho might have the least effect when interest rates are low. This is true unless a substantial change in interest rates is expected.

Using the Greeks to Better Understand Combination Trades

As you can see, an important property or trait of all the Greeks, such as Theta, is that they are additive across various options on the same underlying asset or security. As a result, it is simple to calculate Greeks for option strategies, such as straddles and condors. You can do this by simply adding them for all the individual options.

Also, keep in mind that besides using the Greeks, such as Rho, on individual options, you may use them for positions that often combine multiple options. This is important as it can help you quantify the various or unique risks of every trade you consider.

Keep in mind that option positions have various risk exposures. Also, these risks vary considerably over time and with market movements. This is why you should have a simple way to understand them.

The best thing about Greeks is that they let you see just how sensitive the position is to fluctuations in volatility, stock price, and time.

Final Thoughts 

There is no doubt that option Greeks will help you understand the important measurements of the risks of an option position as well as its potential rewards. Once you know and understand the various characteristics of these option Greeks as well as how they affect the options price, you can apply this to your option strategies.

Trading options is a bit more advanced and complicated than selling and buying stocks or mutual funds. Although options trading can be riskier than other kinds of trades, there can certainly be the potential for considerably higher rewards too.

Greek letters are often used in the modern investment community in order to represent various ways to measure and mitigate risks when trading options. And learning the option Greeks terminology will help you better navigate options trades as well as the associated risks. However, you should know that the Greeks don’t work in isolation. They are also constantly changing. This means that a change in one Greek, such as Gamma, can impact all the other Greeks.

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