Getting to know the Greeks
If you’re just getting into options, you’re probably hearing terms thrown around like “delta” and “theta.”
These are part of “the Greeks” -- a set of metrics to estimate how an option price will change based on three things:
- The stock-price/option-strike relationship
- Implied volatility (IV)
- Time value
Delta is probably the most popular Greek. It shows how much an option price will change with any $1 gain or loss in the stock price.
Some would also say that delta shows the option’s chance of expiring in the money (ITM) -- which is when the stock price is above the call strike or below the put strike.
Call options have a positive delta between 0 and 1, and put options have a negative delta between 0 and -1. This is because calls gain value when a stock moves higher, and puts gain value when the stock falls.
A call option with a delta of 0.50 means that call’s price will increase by 50 cents for every $1 increase in the stock price. It would also suggest a 50% chance of that call being ITM on expiration day.
The price of a put option with a delta of -0.65 would increase by 65 cents for every $1 drop in the stock price. It would also point to a 65% chance of being ITM on expiration.
As option sellers, we don’t want our sold options to finish in the money, as that would mean the buyers on the other side of the table won.
Gamma measures how much the delta will change with every $1 change in the stock price.
So, let’s say the 100-strike call option for a stock trading at $97 has a gamma of 0.10. The delta on the call is 0.40.
A $1 uptick in the stock price would boost the option’s delta by 0.1 point, or 10 percentage points, to 0.50.
Because at-the-money (ATM) options -- when the stock price is at or near the option strike -- are most sensitive to stock fluctuations, gamma is highest on these types of options. Gamma will be closer to zero for options that are way out of the money (OTM) or deep ITM.
Vega illustrates how an option price will change based on a 1% change in the contract’s implied volatility.
If a call option is priced at $10, and has a vega of 0.20, and the option’s IV rises by 1%, the call price would increase to $10.20. If the IV goes down 1%, the call price would dip to $9.80.
The more time until the option expires, the higher the vega. So, a 1% change in IV would have a bigger impact on long-term contracts like LEAPS (Long-Term Equity AnticiPation Securities, which are options that can trade several years out) than short-term contracts like weekly options
And since IV tends to increase ahead of a known event, like an earnings release, vega will increase on the stock’s options as the event approaches.
Finally, theta measures an option’s time value -- or, rather, how much an option price will decrease each day.
If someone buys an option with a theta of -0.20, it will shave off about 20 cents a day heading into expiration, assuming the stock price remains constant.
Theta accelerates as expiration gets closer, so a high theta value is good for sellers, since time decay is our friend. Very long-term options have a theta close to zero, while short-term options -- particularly ATM contracts -- will see big increases in theta as expiration approaches.
This is a very broad outline of options Greeks but for people trying to understand how options work they are very important when finding the correct option contracts to trade.
As always let me know if you have questions.