Measuring Risk; Using ‘The Greeks’

Attention option rookies:  It's time to spend some time discussing 'the Greeks.' 

It's difficult to spend much time reading about options without encountering several mentions of specific Greek letters.  If those encounters have been confusing, I hope this simple lesson brings clarity.

One of the advantages of trading options instead of stocks or index funds is that it's far easier to measure and manage risk.  With stocks, the risk is pretty much limited to how much the stock can rise or fall.  When dealing with options, you can track risk associated with stock price movement, implied volatility, the passage of time, varying interest rates, plus others that we will avoid here. [I haven't paid much attention to others for many years.]

It has universally been accepted to use Greek letters (except that one of the letters is not Greek!) to express those risk factors.   

There are five basic Greeks that are used by the majority of investors, but there are others that are used only by those who are more sophisticated and who seek  any tiny edge then can accumulate when trading.

For our purposes, let's talk about delta, gamma, vega, theta, and rho.

The term
'approximately' is used below because there are several risk factors in play simultaneously,
and each affects the price of an option. 
You can estimate the effect of a specific risk factor (Greek), but cannot know with certainly how the option price will be affected in the marketplace because all variables are coming into play at the same time.

EXAMPLE: A stock moves from 40 to 41.


Delta
is an estimate of how much the price of an option changes when the underlying asset moves one point.

Call options have a positive delta.
Put options have negative delta.

In the example, a call option with a delta of .60 should increase in value by approximately $0.60.  Similarly, a put option with a delta of -.25 should decrease in value by approximately $0.25


Gamma
is an estimate of the rate at which delta changes when the underlying asset moves by one point (in either direction).

Gamma is always a positive number. 

If the gamma of an option is five (that means 0.05), then the delta of the call (example above) increases by five when the stock moves one point higher – from .60 to .65.  It decreases by five when the stock moves one point lower, from .60 to .55.

NOTE:  In our example, the call option began with a delta of .60 and ended with a .65 delta.  Thus, over the one point move from 40 to 41, the average delta was 0.625, and the option price is expected to increase by $0.625, not $0.60

If the put has a gamma of two, then the delta moves from -25 to -23 when the stock moves from 40 to 41, and would move from -25 to -27 if the stock declined from 40 to 39.

Theta represents the value of an option that is lost as one day passes.  Options are wasting assets, and theta measures the rate of decay.

Vega is not Greek, but no one seems to mind.  It measures the change in the value of an option when the implied volatility (IV) increases by one point.  Vega is a positive number and is the same for the put and call with the same strike and expiration.  Both options increase in value when IV increases.

Rho represents the change in the price of an option when interest rates increase by one point.  Rho is the least important of these risk parameters and only becomes important when the option has a long lifetime (thinks LEAPS) or interest rates undergo a drastic change.

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