The Greeks are a set of statistical measures used in options trading that are each represented by a letter from the Greek alphabet. Since options are priced based on the projected potential future price action of the underlying security, these statistical measures are essential to understanding the price of options.
While many options traders use the Greeks in complex formulas, they are also often useful as a form of shorthand for quickly and efficiently sorting potential trades or other similar investment decisions in the options markets.
Delta is an option Greeks that measures of the price relationship between an options contract and its underlying security.
For example, take a call option with a Delta of 0.5. If the price of the underlying security increases by $2, then the price of the call option will increase by $1.
Vega is a measure of the relationship between the implied volatility of an option, or the volatility of the underlying asset, and the price of the option.
The price of options are heavily influenced by the volatility of the underlying asset, since a greater volatility means a greater likelihood that the price of the security will reach or exceed the strike price of the option at some point on or before the option’s expiration date.
Therefore, changes in the volatility of the underlying security lead to direct changes in the price of any associated options contracts, and the Vega for each option is the measure of that price change.
Theta is a measure of an option’s time decay of value.
Every option represents a potential payout over a period of time depending on the price action of the underlying security over that period. Therefore, the longer an option’s expiration date, the greater the value of the option, as it has a greater chance of becoming profitable the longer the time until expiration.
The Theta for all options is negative, since time is always diminishing for all options. Theta tends to become increasingly negative as it approaches the option’s expiration date.
Gamma is a measure of the rate of change in an option’s Delta.
As the price of an option changes according to its Delta, so to does its Delta change according to the option’s Gamma.
Gamma is a constant measure that allows traders to estimate the likelihood of an option reaching its strike price.
Rho is the measure of the change in an option’s price resulting from a change in interest rates.
Most options are only marginally affected by interest rate changes, but longer-dated options are more affected because interest rates represent a risk-free alternative that investors could be accruing with the capital that was spent on the option’s initial premium.
Final Thoughts – Option Greeks
While many traders find the Greeks in options trading to be intimidating at first, they are utterly essential to effective options trading. Not only are they necessary for the creation of more complex and nuanced options positions, but they can also be used as shorthand to efficiently navigate options tables and make rough options trading decisions.