Options - It's Greek to Me
By : Rodney Trotter
Usually when you hear the phrase - it's Greek to me, it means the speaker does not understand something. When trading options, risk is revealed in the Greeks and is something you need to understand. The option Greeks are delta, gamma, theta, rho and vega. In this article I will cover definitions of these measures. Check out It's Greek to Me - Delta and Gamma, It's Greek to Me - Theta and Rho and That's Not Greek to Me - Vega to complete your Greeks lessons.
Option pricing models (such as Black-Scholes or Cox-Ross-Rubenstein) use several variables to determine an option's theoretical value. These include the underlying asset's market price, option strike price, time left to expiration, volatility and short-term interest rates. All these pieces of data are readily available and can be used in option calculators to determine theoretical value. The calculators at VolatilityTrading.net will also give you all the Greeks using models for both American and European options, and dividend paying assets.
Delta is the change in an optionís premium relative to a change in the price of the underlying asset. Delta on call options varies between 0 and 1. Put options have negative delta. An option with a delta of .50 will move a half-point for every 1-point move in the underlying asset.
Gamma is the change in delta relative to a change in the underlying asset. Unlike delta, which is highest for deep in-the-money (ITM) options, gamma is highest for at-the-money (ATM) options and lowest for deep ITM and out-of-the-money (OTM) options.
Rho measures the change in option premium relative to the change in the risk-free interest rate. You can also think of rho as the sensitivity of option premium to the cost money.
Theta measures the rate at which the option premium decays each day (the rate of time decay). Theta increases as the option gets closer its expiration date.
Vega reflects how much an optionís premium changes with each 1-percent change in implied volatility.
Each of these measures give you a handle on how you option position value will change based on asset price changes (delta and gamma), interest rate changes (rho), time to expiration (theta) and volatility (vega). As you become familiar with the Greeks, you will be able to quickly evaluate risk based on these 5 values.
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