Updated: Apr 8, 2021
Now, In this article, we are going to learn about the options Greeks. If you are an options trader, then you are surely friendly with the concept of option Greeks. These are an estimate of sensitivities. Effectively, Option Greeks estimate the sensitivity of the option price to various parameters that affect the value of an option. Such sensitivity can either be on the upside or the downside. When we speak of the option price here, we refer to the value of the option as find out by the Black & Scholes model.
Some of the factors influence an option's contract’s strike price. These factors can either impact or help traders depending upon the type of positions they choose to take. Successful and specific traders are aware of the factors that affect options strike price. These factors include the famous ‘Greeks:’ a set of four risk estimates named after Greek letters. Each of the letters individually affects how sensitive a particular options contract is to changes in direction of the market, implied volatility, time-value decay, and movement in the price of the stocks. These estimates are therefore referred to as Delta, Gamma, Vega, Theta, and Rho. You can remember it as DGVTR.
Before we jump into understanding options Greeks, let’s mark what the purpose of options contracts is, to begin with. The goal of options contracts is to hedge a portfolio and offset any potentially unfavorable up or down moves seen in other investments. One can also depend 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 certain security at a predetermined price at some point in the future.
Options can be used such that they are changed into shares of the underlying asset at the pre-set price on the contract which is known as the strike price. Each option contract has an ending date known as its expiration date as well as a cost or value that is attached with its buying known as its premium.
Delta estimates the sensitivity of an option's theoretical value to a change in the price of the underlying asset. It tells us the direction of the market. It is normally measured as a number between minus one and one, and it denotes how much the value of an option should change when the price of the underlying stock goes up by one Rupee.
Since delta is such an essential factor, options traders are also interested in how delta may change as the stock price go up or down. Gamma estimates the rate of change in the value of delta for each one-point increase in the underlying asset. It is a beneficial tool in helping you predict changes in the delta of an option or an overall position. Gamma will be larger for at-the-money options and goes increasingly lower for both in the money and out of the money options. Unlike delta, gamma is always positive for both call options as well as for puts options.
Theta is an estimate of the time decay of an option, the rupee amount an option will lose each day due to the decay of time. For the money options, theta increases as an option go towards the expiration date. For in the money and out of the money options, theta decreases as an option goes towards the expiration date.
Theta is one of the most important concepts for a beginning options trader to understand because it tells you the effect of time on the premium of the options buying or writing. The further out in time you go, the smaller the time decay value will be for an option contract. If you want to keep an option, it is an advantage to buy longer-term contracts. If you want a method that profits from the time decay of options, you will need to short the shorter-term options, so the loss in value due to time happens faster.
The next Greek we will look upon is Vega. Many people find confusion between Vega and volatility. Volatility estimates fluctuations in the underlying asset. Vega estimates the sensitivity of the price of an option to changes in volatility. A change in volatility will affect both calls option and puts option the same way. An increase in volatility will increase the prices of all the options on an underlying asset, and a decrease in volatility affects all the options to decrease in value.
However, each particular option has its own Vega and will react to volatility changes a bit diversely. The impact of volatility changes is greater for at-the-money options than it is for the in the money and out of the money options. While Vega influence calls and puts similarly, it does appear to affect call options more than puts options. Perhaps because of the expectation of market growth over time, this effect is more pronounced for longer-term options.
The final Greek is Rho. Rho is the rate at which the strike price of a derivatives asset changes relative to a change in the risk-free rate of interest. Rho estimates the sensitivity of an option to a change in interest rate. Rho may also refer to the quantity of risk display to interest rate changes that exist for a book of several options positions.
In addition to the risk factors given above, options traders may also look to the second and third-order derivatives that tell us the changes in those risk factors given changes in other variables. While less commonly used, they are nonetheless useful for obtaining a full grasp of an options position's complete risk profile.
Some of these minor Greeks that are used: Lambda, Epsilon, Vomma, Vera, Speed, Zomma, Colour, and Ultima. But in my opinion, I generally don’t use these options Greeks.