Assuming that you already know what an option is and that you understand the basic characteristics of puts and calls, then the next  logical step in your options education is study of the option Greeks.

Option Greeks

The Black-Scholes option pricing model computes the theoretical value of options using several “Greek” letters. These greek letters are used in the pricing model equation, and are represented as delta, theta, gamma, vega and rho.

The Option Greeks measure the sensitivity of the price of stock options in relation to a variety of factors. These factors include changes in the underlying stock price, interest rates, volatility, time decay.

Option Greeks allow option traders to objectively calculate changes in the value of options with regard to the changes in the factors that affect options. Mathematically calculating  changes in the option Greeks helps option traders hedge their portfolio by deploying specific risk/reward profiles. Therefore, understanding the Option Greeks is extremely important to option traders.

Most novice traders typically understand that by knowing the delta of an option provides valuable information.  Deltat provides an indication of how an option’s value will change with movements in the underlying stock price, provided all other variables remain unchanged.

Knowing time decay, represented by theta, tells the option trader how much time value an option trade may lose each day, considering all other variables to remain the same.

More advanced options traders use the Option Greeks, in combination, to help determine exactly how many options are required to hedge their overall position. These more advanced traders can also adjust their hedge in order to remove certain risk factors from their portfolio.

Option Greeks enable the trader to determine how much risk a trade or portfolio is exposed to, and where that risk lies.  For example, risk may arise from volatility (vega) or time decay (theta). Therefore, it is important to have a solid understanding and working knowledge of the option Greeks.

Any options trade must have a solid options education and must understand the option Greeks.  An options education that provides a basic understanding of the option  Greeks will probably help most options traders.

The Option Greeks

  • Delta is a measure of an option’s sensitivity to changes in the price of an underlying asset (stocks or futures).
  • Gamma measures the delta’s sensitivity to changes in the price of the underlying asset.
  • Vega – measures an option’s sensitivity to changes in the volatility of the underlying asset.
  • Theta  measures an option’s sensitivity to time decay.
  • Rho measures an option’s sensitivity to changes in the risk free interest rate (not typically considered when trading futures options).