What You Need to Know About Greeks and Options

Greeks and options?! Is this referring to a college fraternity dedicated to trading options? Or perhaps an ancient option trading arena that was recently discovered in Athens?

Actually, neither. In option nomenclature, the Greeks refer to the measure of risk associated with option trading. Many new traders are totally confused by these complicated sounding terms, believing that they really are dealing with a subject outside of their ability.

Nothing could be further from the truth, Option Greeks are simple concepts hidden in complex, scientific sounding terms. This article will define each of the 4 commonly used Option Greeks and explain how they are used. The 4 Greek terms are Delta, Gamma, Theta, and Vega.

DELTA

This is the most commonly used Greek. Delta is the measurement of how much an option's price changes for every $1.00 change in the underlying stock. An option is said to have positive delta if it goes up when the stock price goes up. Negative Delta is the term used when the option price goes up if the stock price falls. A long call, meaning when you buy a call, the trade has positive Delta. A long put, meaning purchasing a put, has negative Delta.

A call's delta is measured 0 to 1 and a put's delta is measured 0 to -1. The closer the delta is to 1 or -1, the more the option is expected to move in relation to the stock price. A good way to visualize delta is to understand that being long a stock means the delta is 1, short a stock, delta is -1. Therefore, owning a call with a delta of 1 means the call will move exactly like the underlying stock. Delta is largely dependent on the stocks price relative to the strike price of the option. It is important to note that delta is theoretical and assume that time, volatility and interest rates remain the same.

GAMMA

Gamma is a little more complicated that delta, but still an easy to grasp term. Gamma estimates the degree of change in the delta when the underlying stock moves $1.00. It is used to let the trader know how smooth the delta will be, meaning a small gamma means the delta will stay relatively flat during small stock moves, and a large gamma means the delta will change sharply during small stock moves.

Long calls and puts have positive gamma, short calls and puts have negative gamma. Positive gamma refers to the fact that the delta of long calls will become more positive, moving toward 1 as the stock price rises. It also means that the delta of long puts will become more negative as the stock price falls and move toward -1. Gamma is the highest for an option that is At The Money or ATM. ATM means the stock is at the strike price.

Gamma progressively lowers as the option moves away from being ATM, in either direction, out of the money OTM or in the money ITM. The important thing to take away from understanding gamma is a position with a positive gamma will move with the stock, deltas will change with the up or down stock movement. Positions with a negative gamma can create deltas that can hurt the position as the stock moves.

THETA

Theta is just a fancy word for time decay. An easy way to remember is both TIME and THETA begin with T. It is the estimate of how much the value of an option changes as each day passes toward expiration. It assumes that there is no change in the stock price. Being long a call or a put means you have negative theta. Short the same call or put means you have positive theta. Think of it this way, when you sell an option, time is working for you therefore it is positive theta. When you buy an option, time is your enemy, therefore the position has negative theta.

VEGA

Vega is a measure of how much the price of the option changes for every 1% change in volatility. An easy way to keep this straight is to remember VEGA and VOLATILITY both begin with V. As volatility increases, so do the prices of options and vice versa. This is due to the fact that increased volatility means more stock price swings increasing the possibility of the option making money by expiration. A long call and put have positive vega, short calls and puts have negative vega. Positive vega means the option price increases when volatility increases. Negative vega means that the option price decreases when volatility increases. Vega is the highest for ATM options and decreases as the price moves either ITM or OTM.

Dave Goodboy is Vice President of Marketing for a New York City based multi-strategy fund.