Options Greeks explained for beginners: You must have heard about traders making money through options trading. There is no denying that trading in options is quite risky due to the volatility in the options pricing and the outcomes.
But higher risk means higher returns. We advise the traders to trade in options by understanding and having a fair idea about the risk factors affecting their pricing and Options Greeks.
In this article, we will try to get you Options Greeks Explained and make you understand how to measure the sensitivity of an option’s price to some quantifiable factors. By the end of this article, you should have an idea about the concepts which can help understand the risks and potential rewards of taking positions in options.
Predicting what can happen to an option’s price due to changes in the market landscape can be a challenging and difficult task. Since an option’s price does not appear to move in tandem with the price of an underlying asset, understanding the factors contributing to the movement in option pricing is of utmost importance.
List of Options Greeks used by Traders (Options Greeks Explained)
Option traders refer to Delta, Gamma, Vega, Theta, and Rho as their positions when evaluating various risk factors. Collectively, they are known as “Greeks”-A pack of risk measures named after Greek letters. Read on to understand the different types of Greeks –
Delta helps in measuring how much a price of an option can be expected to move for every $1 change in the price of the underlying asset. A Delta of 0.30 means an option’s price will theoretically fluctuate by $0.30 for every $1 change in the underlying asset’s price. You guessed it right! Higher the Delta, the bigger the change in price.
However, this does not mean that higher-Delta options should result in profits. This is because if a trader has paid a large premium for an option that expires in the money, he might not book profits. Option traders use this measure to predict whether or not a given option will expire in the money.
In simple terms, a Delta of 0.30 means that an option has a ~30% chance of being ITM at expiry. Call options have positive Delta, ranging from 0.00 to 1.00. Put options have negative Delta, ranging from 0.00 to –1.00.
Gamma helps in measuring a change in Delta in case the price of underlying asset changes. Basically, Gamma is a rate of change in option’s Delta per $1 change in the underlying asset’s price.
Gamma is helpful in predicting the price moves of an underlying asset. Since Delta can’t exceed 1.00, Gamma decreases as the option gets further in the money and as Delta reaches closer to 1.00.
When an option that is being measured is deep in or out-of-the-money, the value of gamma is small. When the option is near or at the money, gamma’s value is the largest. Long calls and long puts have positive Gamma. Short calls and short puts yield negative Gamma.
Theta helps in determining how much an option’s price should fall with each passing day as the option approaches expiration, considering that other factors remain the same. This erosion of price is called time decay. Theta is usually expressed as a negative number. Time decay favors a trader who writes an option.
Option writers benefit from decay because options that have been written become less valuable as the expiration date approaches near. It is cheaper for option writers to purchase back the options so that they can close their short position. Option values are made up of both, extrinsic and intrinsic values. When an option expires, the only intrinsic value remains.
Vega helps traders measure the rate of change in an option’s price per one-percentage-point change in implied volatility of the underlying asset. Simply put, Vega helps in understanding how sensitive an option might be to any fluctuations in the prices of the underlying asset.
Implied volatility means forecasting the volatility of an underlying asset in the near future. However, this is theoretical. Even though it is possible to predict a stock’s future moves by checking its historical performance, among several other factors, implied volatility which is reflected in the option’s price is an inference based on several other factors.
These factors include expected earnings reports, news about M&As, diversification in new geographies, board appointments, etc. Drop-in Vega will cause both, calls and puts, to decay in value, while a rise in Vega will lead to gains in values.
Ignoring Vega can result in traders overpaying at the time of options buying. All other factors considered equal, traders should go long on options when Vega is below normal levels and consider selling options when Vega is above normal levels.
Rho measures an anticipated change in the price of an option per one-percentage-point change in the interest rates. It tells traders how much an option’s price should increase or decrease if the risk-free interest rate rises or falls. As and when interest rates rise, the value of call options should increase and the value of put options usually decreases.
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Is Higher Delta Better For Options?
Delta ranges from 0 to +1 for call option and 0 to –
1 for a put option. When you buy a call, the higher the delta, the better the chances of your options contract expiring in-the-money. When you buy a put, the lower the delta, the better the chances of your options contract expiring in the money.
We tried to explain how to calculate the sensitivity of an option’s price to certain measurable parameters in this article. We hope you now have a better understanding of the ideas that might assist you appreciate the risks and possible rewards of taking options positions.
So that concludes the “Options Greeks Explained” post. Please let us know what you think in the comments area below. Happy investing!
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