When you invest in an options trading strategy, you're not just buying the right to sell or buy a stock at a certain price. Options have so much more depth than that. Each option has peculiarities and risks that are even more complicated by four Greek letters. These four letters are known as the "Option Greeks" because they describe key risk factors for every option strategy: delta, gamma, theta, and vega. Understanding how these risk factors work can be tricky if you're not used to thinking about advanced financial concepts. But it's essential knowledge if you want to succeed as an options trader.
Before we understand the topic, let us find out the functions of options contracts in the financial markets. The main mission of these instruments is to hedge a portfolio and offset any probable unfavorable moves that occur in the other investments in the financial portfolio. An investor can also use options instruments to speculate on whether the price of an underlying asset may fall or rise. Utilizing any put options helps the holder sell the underlying security at a predetermined price. The transaction happens at a specific point in the future. A call option permits the investor to buy a specific instrument at a predetermined price soon. The options instruments can be utilized such that they are converted in stock of the underlying asset at the fixed price on the contract, called the strike price. All options instruments have an ending date called the expiration date, and the value or cost related to the purchase is called the premium.
The cost of the option or the premium is usually based on the pricing model of the options. This eventually leads to volatility in the premium of the options. The options greeks are examined in conjunction with the pricing model of the option instrument to find out any risks associated with the contract.
The first option Greek we'll discuss is delta, which measures how much the cost of an option will change when the cost of the underlying asset changes. In particular, delta tells us how much the option price will change for a one-dollar move in the underlying security. A more accurate way to think about delta is the option's "shifting price." It tells you how much an option's price will change given a certain change in the underlying asset price. As the cost of the underlying stock changes, the delta of your option will change. The higher the option's delta, the faster its price will change as the price of the underlying stock changes. The delta of an option is always expressed as a number between 0 and 1. A delta of 0 means that the option's price won't change as the price of the underlying security changes. A delta of 1 means that the option's price will change directly to the underlying security's price. For example, let's say you buy a call option with a delta of 0.5. If the underlying security price rises by $1, the option's price will rise by 50 cents. If the underlying security goes up by $5, the option's price will go up by $2.50.
Gamma is the amount that the delta of an option modifies when the price of the underlying asset changes. Gamma is the second option for Greeks, and it is expressed as a number between 0 and 1. A gamma of 0 means that the option's delta will not change as the underlying asset's price changes. A gamma of 1 means that the option's delta will change by an amount proportional to the underlying security's price. It's important to distinguish between the two Greeks that deal with the option price change. Delta is the amount the option's price changes when the underlying security's price changes. Gamma is the amount the option's delta changes when the underlying security's price changes. Remember that the option's price change will always be based on its delta. So, if the option's delta is 0.5 and the underlying security's price changes by $1, the option's price will change by 50 cents. But if the underlying security's price changes by $1, the option's delta will change by 0.5.
Theta measures how much the option's price will change due to time passing. The options Greek theta is expressed as a dollar amount per day. If the option's theta is $0.50, then the option's price will drop by $0.50 for every day that passes. The option price will drop by $1 after a week, $10 after a year, etc. Time has a very real impact on the prices of options. The longer you hold an option instrument, the more its price will decrease. This is true even if the underlying security's price remains unchanged. Options have an embedded time value that will erode their price over time. Theta is most important for options that have a long time until expiration. At-the-money call options have little time value, so they have almost no theta. But out-of-the-money call options have a very high theta because they have a very long time until expiration.
Vega measures how much the option's price will change when the volatility of the underlying security changes. Vega is the last of the options for Greeks. Volatility is one of the most vital factors that determine option prices. But volatility is also one of the most difficult factors to predict. A jump in volatility will have a disproportionate effect on options with short terms until expiration. For options with a long time until expiration, even a large change in volatility will only impact the price. The Vega of an option tells you how much the option's price will change if the volatility of the underlying security changes. The higher the Vega, the greater the impact a change in volatility will have on the option's price.
You may be a more advanced trader of options contracts in the financial markets. Then you might have seen that we have not listed one of the option greeks here, which is called the rho. It is the amount of change that the value of an option instrument will experience in theory. It is based on a single percentage-point modification in the rates of interest. Usually, this value is not mentioned when one talks about options greeks. People who are really serious about trading in options instruments in the financial markets get to know this value better over time. For now, you should just remember that you are trading in options with a shorter expiry time. The changing interest rates will not greatly affect your options' value. But if you want to trade longer-term options, it can have a greater effect because of the higher cost to carry.
The four option Greeks (delta, gamma, theta, and Vega) are more than just numbers that measure risk. They also provide valuable insight into how each options strategy will behave in different market conditions. Let's look at each option Greek and see how it can help you manage risk in your options trading strategy. Delta will tell you how sensitive your option is to the underlying security's price changes. If the underlying security's price goes up and down, you'll want a delta closer to 1. If the underlying price is fairly stable, you'll want a delta closer to 0. Gamma will tell you how sensitive your option's delta is to underlying security's price changes. If you want your option's delta to change quickly as the underlying security's price moves, you'll want a high gamma. But suppose you want your option's delta to change slowly as the underlying security's price moves. In that case, you'll want a lower gamma. Theta is most important when you want to know how long you can hold an option before it becomes worthless. The longer an option's time to expiration, the more its price will be affected by theta. Vega will tell you how sensitive your option's price is to changes in volatility. High-volatility stocks will have high Vega.
The first option Greeks are delta, which measures how much the price of an option will change when the cost of the underlying asset changes. The second option Greek is gamma, which measures how much an option's delta changes when the underlying asset's price changes. The third option in Greek is theta, which measures how much the price of an option will change as a result of time passing. The last option Greek is Vega which measures how much the price of an option will change when the volatility of the underlying security changes. These option Greeks provide useful information about how different options strategies will behave given different market conditions. The option Greeks can help you manage risk in your options trading strategy.