A slew of factors influences an options contract’s price. These factors can either hurt or help traders depending upon the kind of positions they choose to take. Successful and seasoned traders are aware of the factors that affect options pricing. These factors include the popular ‘greeks:’ a set of four risk measures named after Greek letters. Each of the letters individually affects how sensitive a particular options contract is to changes in implied volatility, time-value decay, and movement in the price of the security. These measures are therefore referred to as ‘vega,’ ‘theta,’ gamma,’ and ‘delta.’
Understanding Options Contracts
Before we dive into understanding options greeks, let’s address what the purpose of options contracts is, to begin with. The goal is to hedge a portfolio and offset any potentially unfavorable moves seen in other investments. One can also rely on options contracts to speculate on whether an asset’s price may rise or fall. In short, using a put option allows a holder to sell the underlying security at a predetermined price at some point in the future. Alternatively, a call option allows the trader to purchase a certain security at a predetermined price at some point in the future.
Options can be used such that they are converted into shares of the underlying asset at the predetermined price on the contract which is known as the strike price. Each options contract has an ending date known as its expiration date as well as a cost or value that is associated with its purchase known as its premium. The price of the option — its premium — is typically based on the options pricing model, like that by Black-Scholes, which eventually causes fluctuations in its premium. The four options greeks are often viewed in conjunction with the option’s price model so one can understand and gauge any associated risks.
Option Greeks Meaning
Now that we know the answer to what is an options greek, breaking down what each of the four options greeks signify is vital.
Delta: Measuring the impact of a change in the underlying security’s price. An option’s price — the premium of that option — can change over time due to the performance of its underlying security. Delta’s value will range anywhere between -100 to 0 for put options and between 0 to 100 for calls. Put options normally generate a delta that is in the negative range. Put options ten to have a negative relationship with the underlying security. Put premiums fall when the price of the underlying security increases, and vice versa.
Gamma: Measuring the rate of change of Delta The value of Delta is constantly fluctuating. This fluctuation is in conjunction with the price of the underlying security. Gamma is used in accordance to measure the rate of fluctuation so traders can get an idea of how volatile the Delta is before investing. Values of Gamma are the lowest for those who find themselves deep in or-out-of-the-money. Gamma can help in determining the likelihood that an option will reach its strike price at expiration, based on how stable the delta is.
Theta: Measuring the effect of a change in the remaining time — or time decay in an options contract’s value. The more time passes, the lower the chance of the options trade yielding returns. As the date of expiration draws closer, time decay accelerates. Theta is, therefore, always a negative value. In general, as soon as one purchases an options contract, the clock begins ticking and theta’s value keeps growing.
Vega: Measuring the effect of a change in volatility. The higher the volatility, the more expensive the options contract. This is because there is a higher chance of the underlying security hitting the strike price at some future point. The purpose of Vega is to reveal — within the level of implied volatility — how much the price of an option will decrease or increase. If there is a fall in the implied volatility, the buyer of an options contract is set to benefit.
There are four types of options greeks namely — delta, gamma, theta, and vega. Each type measures certain factors associated with an options contract such as the fluctuation in the price of the underlying security, the amount of volatility, and time decay of the options contract. Collectively, all four options greeks allow an options trader to gain insight into their contract and its value.