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Option Greeks for Beginners

Optimize Your Option Trading by Understanding the Greeks

Wealth Management on Ulitzer

New option traders often struggle with unpredictable pricing - the mathematical value of an option may or may not be the actual or perceived value at any given time. The reason for the disparity? The 'Greeks'. Fortunately, understanding how the Greeks can impact option pricing is pretty simple to learn.

There are four primary option Greeks all option traders should become familiar with. Two of them generally need to be considered before choosing an option to trade. The other two may not be of great value for newcomers in terms of selecting an option. However, they should be understood all the same, even if only to be aware of potential influences on that option's price.

Delta

Delta is a measure of responsiveness of an option's price relative to the change in price of the underlying security. For instance, if IBM calls have a delta of 0.8, for every $1 that IBM rises, the IBM calls will rise by 80 cents per share, or $80 per contract.

In the case of put options, delta is expressed as a negative number.

Theta

Also known as time decay, 'theta' is the amount of daily reduction of an option contract's value as the expiration date approaches. The amount is generally expressed as a negative number, though some data providers simply display the amount of daily loss as a positive number. It's also important to understand that some data providers express theta for an entire contract, while others might supply a theta value simply for one underlying share. Since an option contract represents 100 shares of a stock, in the latter case the theta value would need to be multiplied by 100 to determine the daily value decline of a contract.

Using the IBM call example again, a theta of -.10 would mean the contract loses $10 per day just due to the passage of time.

Obviously theta and delta have an immediate impact - for better or worse - on an option's value. For this reason, most traders compare several 'what if' delta and theta scenarios before choosing an option.

Vega

The higher the volatility for any asset, the greater the premium of the option. However, premiums for some options increase by more than other options, even if the change in underlying asset's volatility is the same. Vega is the measure of that sensitivity of an option's price relative to changes in volatility of the underlying asset (stock or index). So, vega allows a trader to compare the potential volatility-based increase in premiums of two different options.

If the vega for those IBM calls is expressed as 0.25, an increase in volatility from 10% to 11% would mean the option's premium would increase by $0.25, or $25 per contract.

Gamma

Gamma indicates the rate of change in the delta value for every $1 move in the underlying asset. If IBM calls have a delta value of 0.8, and the gamma value is 0.05, when IBM shares rise $1 then the new delta value becomes 0.85.

For many advanced traders, vega and gamma are factored into the option selection strategy. For most novice traders however, vega and gamma only add confusion without adding any substantial benefit.

New option traders typically find mastery of delta and theta is enough of a challenge in their learning stages.

More Stories By James Brumley

James Brumley is a freelance writer and registered investment advisor. He began his career as a broker with a major Wall Street firm, where fundamentals and long-term holding periods were core strategies. After that, he switched gears completely, becoming an analyst at a short-term trading newsletter that focused on technical analysis. He now manages client money using the best of both philosophies. His company, Bluegrass Portfolio Management, offers investors an opportunity to reap superior returns with minimized risk.

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