Introduction to Options Greeks
To accurately predict what might happen to the price of individual options as the market moves isn't an easy thing to do consistently.
To predict what might happen to options positions that effectively combine multiple individual positions, i.e options spreads, is even more difficult. Given that most options trading strategies involve the use of spreads, anything that that can assist you in making such predictions is something you should be familiar with.
The Greeks can be incredibly useful in helping you forecast what will happen to the price of options in the future, because they effectively measure the sensitivity of a price in relation to some of the factors that can affect that price.
Specifically those factors are the price of the underlying security, time decay, interest rates , and volatility.
If you know how prices are likely to change in relation to those factors, you are essentially in a better position to know which trades to make and when. The Greeks will give you an indication of how the price of an option will move relative to how the price of the underlying security moves, and they will also help you determine how much time value an option is losing on a daily basis.
The Greeks are also risk management tools, because they can be used to work out how much risk involved in any given position and exactly where that risk lies.
As such, the Greeks can be used to determine which risk factors need to be removed from a position, or portfolio of positions, and how much hedging is required.
Before you start thinking about what each Greek represents and how it can be used, you should be aware of the fact that each of the Greeks is basically theoretical.
They can be used to measure the sensitivity of price, but they are an indication of how the price will move in relation to various factors. This isn't a garantee though. They are values that are based on mathematical models, and they are essentially only of any use if they are calculated using an accurate model.
Technically, you could learn how to calculate the Greeks yourself, but this a complex process and very time consuming.
Typically, a trader would use software to carry out the required calculations.
There's commercially available software that can be used for this, but most of the best online brokers automatically provide values for the Greeks in the options chains they display. Having this information readily available makes using the Greeks a lot easier.
Delta is arguably the most important of the Greeks, certainly for a large number of traders.
The delta value of an option represents how the theoretical value of it will move in relation to a change in the price of the underlying security, assuming that all other factors are equal.
It's typically expressed as a number between -1 and 1.
A delta value of 1 would suggest that the price would move by an amount equal to the amount that the price of the underlying security moves by. For example, if the price of the underlying security increased by $1, the price of an option with a delta value of 1 would increase accordingly by $1.
For more examples and further details on this particular Greek, please click here.
Theta is also hugely important, and it's related to the effect that time decay has on the price of an option.
The extrinsic value of an option effectively starts to diminish from the moment it is written, right up until the time of expiration: at which point there's no extrinsic value left. This diminishing value is known as time decay, and the rate of time decay can be predicted using the theta value of an options.
Assuming everything else is equal, the theta value indicates the rate at which the extrinsic value will diminish each day.
The higher the theta value option, the faster the effect of time decay.
You can read a more detailed explanation of this Greek here.
Gamma is the value that measures the sensitivity of the delta value of an option to price movements of the underlying security.
Options Pricing & The Greeks
The delta value of an option isn't fixed and it changes as the market conditions change; the gamma value provides an indication of the rate at which the delta value moves in relation to those changes.
So while the delta value is a measure of how quickly the price of an option will move relative to the underlying security, the gamma value is a measure of how quickly the delta value itself will move relative to the underlying security.
This isn't actually as confusing as it sounds.
We have provided a more detailed explanation of Gamma on this page.
Vega indicates how sensitive the price of an option is to changes in the volatility of the underlying security.
It's essentially an indicator of how much the price of an option will move relative to movements in the implied volatility of the underlying security.
The Vega value is slightly more complex than the previously mentioned Greeks, but it's something that you should really try and understand as volatility can, and does, play a big role in options trading.
Please visit this page for more details.
Rho isn't as commonly used as the other four Greeks, but it's still worth learning about it to complete your knowledge of the subject.
The rho value is used to measure how sensitive the price of an option is to changes in the interest rates.
Therefore, it indicates the rate at which the theoretical value will move relative to interest rates.
For more information on the rho value, please visit this page.
The Greeks really can be very useful to traders, and we strongly suggest that you take the time to learn about each of the five types we have mentioned here. However, we really must stress two particular points relating to them.
Introduction to Options Greeks
First, they are all indicators of how prices will theoretically move in relation to other factors and you should never assume that prices will move as specifically as any given value would suggest.
Second, each Greek value is an indication of how the theoretical value will move assuming that all other factors remain the same.
In practice, there are several factors affecting the price of an option at any one time and you need to try and account for all of those factors and not just a single one. In other words, the Greeks are most useful when you use them in conjunction with each other.