Chapter 7: Options
Options traders often refer to the delta, gamma, vega, and theta of their option positions. Collectively, these terms are known as the Greeks, and they provide a way to measure the sensitivity of an option's price to quantifiable factors. These terms may seem confusing and intimidating to new option traders, but broken down, the Greeks refer to simple concepts that can help you better understand the risk and potential reward of an option position.
You should understand the numbers given for each of the Greeks are strictly theoretical. That means the values are projected based on mathematical models. Most of the information you need to trade options—like the bid, ask and last prices, volume, and open interest—is factual data received from the various options exchanges and distributed by your data service and/or brokerage firm.
Delta and Gamma - As the Underlying Stock Price Changes
At its simplest interpretation, delta is the total amount the option price is expected to move based on a $1 change in the underlying security. Delta thus measures the sensitivity of an option's theoretical value to a change in the price of the underlying asset. It is normally represented as a number between minus one and one, and it indicates how much the value of an option should change when the price of the underlying stock rises by one dollar. Call options have positive deltas and put options have negative deltas. Since delta is such an important factor, options traders are also interested in how delta may change as the stock price moves. Gamma measures the rate of change in the delta for each one-point increase in the underlying asset. It is a valuable tool in helping you forecast changes in the delta of an option or an overall position. Gamma will be larger for at-the-money options and goes progressively lower for both in- and out-of-the-money options. Unlike delta, gamma is always positive for both calls and puts.
Theta and Vega - Changes in Volatility and the Passage of Time
Theta is a measure of the time decay of an option, the dollar amount an option will lose each day due to the passage of time. For at-the-money options, theta increases as an option approaches the expiration date. For in- and out-of-the-money options, theta decreases as an option approaches expiration. Theta is one of the most important concepts for a beginning options trader to understand because it explains the effect of time on the premium of the options purchased or sold. The further out in time you go, the smaller the time decay will be for an option. If you want to own an option, it is advantageous to purchase longer-term contracts. If you want a strategy that profits from time decay, you will want to short the shorter-term options, so the loss in value due to time happens quickly. The final Greek we will look at is vega. Many people confuse vega and volatility. Volatility measures fluctuations in the underlying asset. Vega measures the sensitivity of the price of an option to changes in volatility. A change in volatility will affect both calls and puts the same way. An increase in volatility will increase the prices of all the options on an asset, and a decrease in volatility causes all the options to decrease in value.
However, each individual option has its own vega and will react to volatility changes a bit differently. The impact of volatility changes is greater for at-the-money options than it is for the in- or out-of-the-money options. While vega affects calls and puts similarly, it does seem to affect calls more than puts.