What Are the Greeks in Options and Why Are They Important?
Options trading has become popular among retail traders. While Robinhood has been reporting a fall in equities and overall revenues, its option revenues have been strong. Option terminology can be perplexing at times, and one of the terms is “option Greeks.” What are the Greeks in options and why are they important for options traders?
Options are derivatives and get their value from the underlying, which is the underlying stocks in equities. The price action of the underlying is generally the biggest driver of option prices. However, there's more to an option's price than the underlying. This is where the option Greeks come in.
What are option Greeks?
The option price depends on several variables. This includes the price of the underlying, interest rates, volatility, and the time to expiry. Option Greeks measure the sensitivity of the option price to these variables and are a measure of the risk.
There are five types of option Greeks.
The name option Greek comes from the Greek letters that represent the sensitivity of an option to different variables. There are five different types of option Greeks.
These five option Greeks measure the sensitivity of the option price to different variables.
Delta ranges between -1 and +1.
Delta Greek measures the expected move in an option’s price for every $1 movement in the underlying. The delta of a call option ranges between 0 to 1, while the delta of a put option ranges between -1 and 0. For example, a delta of 0.7 means that the call option's price is expected to increase by around 0.7 percent for every 1 percent increase in the underlying.
A higher delta signifies higher sensitivity of an option’s price to the underlying. For a call option that's deep in the money, the delta approaches 1. Similarly, the delta of a deep in the money put option approaches -1.
The gamma Greek is an offshoot of delta only and measures the rate of change in delta in relation to the change in the price of the underlying asset. It's different from the delta in the sense that while delta is for a particular time, gamma measures the change in delta over a period of time.
Theta is a measure of time.
Theta measures the decay in the time value of an option. Options prices are made up of two constituents. The first is the intrinsic value, which depends on the strike price and the underlying’s current price. The second component is the time value, which decays gradually as the option nears expiry.
Rho measures the option’s sensitivity to interest rates.
Rho measures the sensitivity of an option to interest rates. It measures the expected change in an option’s price if the risk-free interest rates rise. All else being equal, the price of a call option would rise if interest rates rise, and fall if interest rates come down. The relationship is converse for a put option and its price generally falls if interest rates rise.
Vega measures the option’s sensitivity to volatility.
Vega measures the option’s sensitivity to volatility. It measures the change in an option’s price for a 1 percentage point change in the underlying’s implied volatility.
While interest rates are usually stable and don’t impact option prices that much, volatility has a significant impact on option prices. Generally, an increase in Vega would lead to an increase in an option price, while a fall in Vega leads to a fall in option prices.
If you're an options trader, it would be prudent to get well versed with these terms. Most brokers provide these values on the platform so that you can gauge the risk associated with your options trade.