What Are the Option Greeks?

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The evangelists of Wall Street just love to preach about risk management. Sermons on stop losses and the doctrine of diversification echo the halls of finance every day. Indeed, the risk protocols for stock trading are well known among the trading masses. Stumble into the world of option trading, however, and discourses on risk turn into gibberish. Terms like delta, theta, gamma, and vega are tossed about to thoroughly confuse the newcomers. It is to these greenhorns that today’s comments on the option greeks are directed.

What Are the Options Greeks?But, hey, if you’re an options trading veteran settle in and read on. Just beyond this sentence lies clarity on the purpose and definitions of the option greeks.

The option greeks allow traders to estimate how much money they will make or lose based on a change in market conditions. What kind of changes are we talking about? Well, primarily a rise or fall in the stock price, the passage of time, or a change in implied volatility.

Since the greeks allow you to quantify risk, they essentially answer the question, “how much?”

Delta

You probably know if you buy a call option you lose money if the stock drops. But how much money will you lose? The option greek delta will tell you.

Delta measures the change in an option’s value given a $1 increase in the stock. If you own a 50 delta call then you will lose $50 for every $1 drop in the stock. Or, alternatively, you will make $50 for every $1 increase in the stock.

Bullish positions, like long calls or short puts, have positive delta since you profit when the underlying stock rises. Bearish positions, like long puts or short calls, have negative delta since you profit when the underlying stock falls.

One of the biggest benefits of using the greek delta is the ability to quickly determine your aggregate exposure on any stock.

Say you have a handful of varying option positions on Apple Inc. (NASDAQ:AAPL). Maybe some are bullish while others are bearish. To get a sense of the net exposure you can simply add up the deltas of each individual position. Whether you have one trade or one hundred trades on AAPL you can distill the risk down to a single number.

Next, we turn to the option greek associated with time decay.

Theta

Stock options are designed to lose value over time. The decay begins slowly but ramps up as expiration approaches.

Suppose you shorted an option in an attempt to exploit the whittling away of an option’s value over time. If you’d like to know how much money you should make per day, consult theta. It’s the option greek that measures how much an option loses per day.

If you buy an option, you have negative theta because time decay is working against you. On the flipside, if you sell an option, you have positive theta since time decay helps your position.

Most option brokers will even add up the theta on all your positions so you can see whether your overall portfolio is positive or negative theta and exactly how much you should be paying or raking in each day. For example, if my portfolio’s net theta is positive 100 then all else being equal I should make $100 due to the passage of one day.

While delta and theta are the two option greeks that arguably receive the most face time, there are two others you’ll typically see listed in your option chains – vega and gamma.

Vega

Vega measures how much an option will change in value given a 1% change in implied volatility.

The vagaries of volatility are best left to a more in-depth discussion. Volatility is an exciting rabbit hole to descend into but it requires a fair amount of digital ink to do justice. Here are the top two points for vega.

  • First, when you buy call or put options you are acquiring positive vega. Essentially you’re long volatility and are poised to score if implied volatility rises throughout the trade. Vega simply tells you how much you will make when implied volatility lifts.
  • Second, when you sell calls or puts you are acquiring negative vega and, thus, short volatility.

Gamma

Gamma rounds out our quartet of option greeks.

The “g” in gamma stands for “growth.” As in the growth of delta. Basically gamma measures the rate at which delta changes when the underlying stock moves $1. As options move in-the-money their delta approaches 1 and as they move out-of-the-money their delta approaches zero. Gamma simply tells traders how quickly the delta is going to change.

And there you have it. The four core option greeks are delta, theta, vega and gamma. Consider them the risk manager’s best friend.

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Article printed from InvestorPlace Media, https://investorplace.com/2017/05/option-greeks/.

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