Using the 'Greeks' to Understand Options

Trying to predict what will happen to the price of a single option or a position involving multiple options as the market changes can be a difficult undertaking. Because the option price does not always appear to move in conjunction with the price of the underlying asset, it is important to understand what factors contribute to the movement in the price of an option and the effect they have.

Options traders often refer to the delta, gamma, vega, and theta of their option positions. Collectively, these terms are known as the Greeks, and they provide a way to measure the sensitivity of an option's price to quantifiable factors. These terms may seem confusing and intimidating to new option traders, but broken down, the Greeks refer to simple concepts that can help you better understand the risk and potential reward of an option position.

Finding Values for the Greeks

First, you should understand the numbers given for each of the Greeks are strictly theoretical. That means the values are projected based on mathematical models. Most of the information you need to trade options—like the bid, ask and last prices, volume, and open interest—is factual data received from the various options exchanges and distributed by your data service and/or brokerage firm.

The Greeks need to be calculated, and their accuracy is only as good as the model used to compute them. To get them, you will need access to a computerized solution that calculates them for you. Most of the retail brokerages (interactive brokers) also provide this information. Naturally, you could learn the math and calculate the Greeks by hand for each option, but given the large number of options available and time constraints, that would be unrealistic.

Below is a matrix that shows numerous option strikes from March, April, and May 2018, for a stock that is currently trading at $60. It is formatted to show the mid-market price, delta, gamma, theta, and vega for each option. As we discuss what each of the Greeks mean, you can refer to this illustration to help you understand the concepts.

The left section shows the call options, while the right section shows the put options. Notice that the strike prices are listed vertically in blue in the middle. The out-of-the-money options are those with strike prices above 60 for the calls and with strike prices below 60 for the puts. The in-the-money options have strike prices of 60 and below for the calls and 60 and above for the puts (the column is highlighted in blue).

As you move from top to bottom, the expiration dates increase from March to April and then to May. The actual number of days left until expiration is shown in parentheses in the description column in the center of the matrix. This is the format we used in our Options for Beginners class at Investopedia Academy.

The delta, gamma, theta, and vega figures shown above are normalized for dollars. To normalize the Greeks for dollars, you simply multiply them by the contract multiplier of the option. The contract multiplier would be 100 (shares) for most stock options. How the various Greeks move as conditions change depends on how far the strike price is from the actual price of the stock, and how much time is left until expiration.

As the Underlying Stock Price Changes—Delta and Gamma

At its simplest interpretation, delta is the total amount the option price is expected to move based on a $1 change in the underlying security. Delta thus measures the sensitivity of an option's theoretical value to a change in the price of the underlying asset. It is normally represented as a number between minus one and one, and it indicates how much the value of an option should change when the price of the underlying stock rises by one dollar.

As an alternative convention, the delta can also be shown as a value between -100 and +100 to show the total dollar sensitivity on the value 1 option, which comprises 100 shares of the underlying. The normalized deltas above show the actual dollar amount you will gain or lose. For example, if you owned the December 60 put with a delta of -45.2, you should lose $45.20 if the stock price goes up by one dollar.

Call options have positive deltas and put options have negative deltas. At-the-money options generally have deltas around 50. Deep-in-the-money options might have a delta of 80 or higher, while out-of-the-money options have deltas as small as 20 or less. As the stock price moves, delta will change as the option becomes further in- or out-of-the-money. When a stock option gets very deep in the money (delta near 100), it will begin to trade like the stock, moving almost dollar-for-dollar with the stock price. Meanwhile, far-out-of-the-money options won't move much in absolute dollar terms. Delta is also a very important number to consider when constructing combination positions.

Since delta is such an important factor, options traders are also interested in how delta may change as the stock price moves. Gamma measures the rate of change in the delta for each one-point increase in the underlying asset. It is a valuable tool in helping you forecast changes in the delta of an option or an overall position. Gamma will be larger for at-the-money options and goes progressively lower for both in- and out-of-the-money options. Unlike delta, gamma is always positive for both calls and puts.

Changes in Volatility and the Passage of Time—Theta and Vega

Theta is a measure of the time decay of an option, the dollar amount an option will lose each day due to the passage of time. For at-the-money options, theta increases as an option approaches the expiration date. For in- and out-of-the-money options, theta decreases as an option approaches expiration.

Theta is one of the most important concepts for a beginning options trader to understand because it explains the effect of time on the premium of the options purchased or sold. The further out in time you go, the smaller the time decay will be for an option. If you want to own an option, it is advantageous to purchase longer-term contracts. If you want a strategy that profits from time decay, you will want to short the shorter-term options, so the loss in value due to time happens quickly.

The final Greek we will look at is vega. Many people confuse vega and volatility. Volatility measures fluctuations in the underlying asset. Vega measures the sensitivity of the price of an option to changes in volatility. A change in volatility will affect both calls and puts the same way. An increase in volatility will increase the prices of all the options on an asset, and a decrease in volatility causes all the options to decrease in value.

However, each individual option has its own vega and will react to volatility changes a bit differently. The impact of volatility changes is greater for at-the-money options than it is for in- or out-of-the-money options. Traders can lessen the impact of implied volatility risk by using a vega neutral strategy.

While vega affects calls and puts similarly, it does seem to affect calls more than puts. Perhaps because of the anticipation of market growth over time, this effect is more pronounced for longer-term options like LEAPS.

Using the Greeks to Understand Combination Trades

In addition to using the Greeks on individual options, you can also use them for positions that combine multiple options. This can help you quantify the various risks of every trade you consider, no matter how complex. Since option positions have a variety of risk exposures, and these risks vary dramatically over time and with market movements, it is important to have an easy way to understand them.

Below is a risk graph that shows the probable profit/loss of a vertical call debit spread that combines 10 long May 60 calls with 10 short May 65 calls. The horizontal axis shows ascending prices of XYZ Corp stock left to right, while the vertical axis shows the profit/loss of the position. The stock is currently trading at $60.22.

The dotted line shows the spread position PNL through May alongside the solid line showing the PNL for today. Obviously, this is a bullish position (in fact, it is often referred to as a bull call spread) and would be placed only if you expect the stock to go up in price.

The Greeks let you see how sensitive the position is to changes in the stock price, volatility and time. The scenarios section has a 10% move in the underlying stock. The table above shows what the predicted profit/loss, delta, gamma, theta, and vega for the position will be on May 16, 2018. It can seem complicated, but if you’d like to learn simple ways to think about the Greeks, you can take Investopedia's Options for Beginners course, which makes an effort to break down these concepts into easily digestible concepts.

Minor Greeks

In addition to the risk factors listed above, options traders may also look to second- and third-order derivatives that indicate changes in those risk factors given changes in other variables. While less commonly used, they are nonetheless useful for getting a full grasp of an options position's complete risk profile.

Some of these minor Greeks include the lambda, epsilon, vomma, vera, speed, zomma, color, and ultima.

These Greeks affect things such as the change in delta with a change in volatility and so on. While lesser-known, they are increasingly used in options trading strategies as computer software can quickly compute and account for these complex and sometimes esoteric risk factors.

The Bottom Line

The Greeks help to provide important measurements of an option position's risks and potential rewards. Once you have a clear understanding of the basics, you can begin to apply this to your current strategies. It is not enough to just know the total capital at risk in an options position. To understand the probability of a trade making money, it is essential to be able to determine a variety of risk-exposure measurements.

Since conditions are constantly changing, the Greeks provide traders with a means of determining how sensitive a specific trade is to price fluctuations, volatility fluctuations, and the passage of time. Combining an understanding of the Greeks with the powerful insights the risk graphs provide can take your options trading to another level.