Trading options offer traders many advantages over stocks, such as inherent leverage and the ability to target specific price levels or trading timeframes. However, options are much more complex instruments than stocks and can be sensitive to more factors than just the underlying stock price. For this reason, options traders need to understand the option sensitivities to various factors. These sensitivities are collectively known as the Greeks due to each sensitivities’ Greek name.
Delta measures the sensitivity of an option’s price to changes in the underlying asset’s price. It ranges from 0 to 1 for call options and -1 to 0 for put options. A positive delta for call options indicates that the option’s price tends to rise as the underlying asset’s price increases. Conversely, a negative delta for put options suggests that the option’s price generally rises as the underlying asset’s price declines.
Example: Suppose you hold a call option with a delta of 0.6. If the underlying stock price increases by $1, the option’s price is expected to rise by approximately $0.60 (0.6 * $1).
Gamma – Rate of Change of Delta
Gamma measures the rate of change of an option’s delta in response to changes in the underlying asset’s price. It reflects how quickly an option’s sensitivity to the underlying asset’s price movements changes. Gamma is highest for at-the-money options and decreases as options move further in or out of the money.
Example: If you have a call option with a gamma of 0.05, and the underlying stock price increases by $1, the option’s delta might increase by 0.05.
Theta – Time Decay
Theta gauges the rate at which an option loses value as time passes, assuming all other factors remain constant. It’s often referred to as the “time decay” of an option. Options with a longer time to expiration generally have higher theta values, as the value of options tends to erode as expiration approaches.
Example: If you own an option with a theta of -0.03, the option’s value might decrease by $0.03 per day, all else being equal.
Understanding Option Greeks
Vega measures an option’s sensitivity to changes in implied volatility. Implied volatility reflects the market’s expectation of future price fluctuations. Higher volatility often leads to higher option prices, and vice versa. Vega is higher for options with longer expiration periods.
Example: If an option has a vega of 0.10, a 1% increase in implied volatility might lead to a $0.10 increase in the option’s price.
Rho – Sensitivity to Interest Rate Changes
Rho indicates an option’s sensitivity to changes in interest rates. Call options tend to have positive rho values, meaning their prices increase as interest rates rise. Put options typically have negative rho values, implying that their prices rise as interest rates decline.
Example: If a call option has a rho of 0.05, a 1% increase in interest rates might result in a $0.05 increase in the option’s price.
Typically traders focus on Delta, Gamma and Vega as the primary sensitivities they need to monitor, although Theta is becoming increasingly important as interest rates increase.