Option Greeks: The 4 Factors to Measuring Risks

An option's price can be influenced by a number of factors. These factors can either help or hurt traders, depending on the type of options positions they have established. To become a successful option trader, it is essential to understand what factors influence pricing, which in turn requires learning about the so-called "Greeks" - a set of risk measures that indicate how exposed an option is to time-value decay, implied volatility and pricing changes in the underlying security. In this article, we'll look at four "Greek" risk measures - delta, theta, vega and gamma - and explain their importance. But first, let's review option characteristics that will help you better understand the Greeks.

Figure 1 lists the major influences on both a call and put option's price. The plus or minus sign indicates an option's price direction resulting from a change in one of the listed variables. For example, when there is a rise in implied volatility, there is an increase in the price of an option, as long as other variables remain static.

Figure 1: Major influences on an option's price

Bear in mind that results will differ depending on whether you are long or short. Naturally, if you long a call option, a rise in implied volatility will be favorable because higher volatility typically gets priced into the option premium. On the other hand, if you establish a short call option position, a rise in implied volatility will have an inverse (or negative effect). The writer of a naked option, whether a put or a call, would therefore not benefit from a rise in volatility because writers want the price of the option to decline.

SEE: The Price-Volatility Relationship: Avoiding Negative Surprises

Figures 2 and 3 present the same variables but in terms of long and short call options (Figure 2) and long and short put options (Figure 3). Note that a decrease in implied volatility, a reduced time to expiration and a fall in the price of the underlying will benefit the short call holder. At the same time, an increase in volatility, a greater time remaining on the option and a rise in the underlying will benefit the long call holder. A short put holder benefits from a decrease in implied volatility, a reduced time remaining until expiration and a rise in the price of the underlying while a long put holder benefits from an increase in implied volatility, a greater time remaining until expiration and a decrease in the price of the underlying. 

Figure 2: Major influences on a short and long call option's price

Figure 3: Major influences on a short and long put option's price

Interest rates play a negligible role in a position during the life of most option trades so we will exclude this price variable from the discussion. However, it is worth noting that higher interest rates make call options more expensive and put options less expensive, all other things being equal.

This summary of pricing influences provide a backdrop for an examination of the risk categories used to gauge the relative impact of these variables. Now let's look at how the Greeks allow traders to project changes in an option's price.

Figure 4 outlines four major risk measures - our so-called Greeks - which a trader should take into account before opening an option position. 

Delta is a measure of the change in an option's price (premium of an option) resulting from a change in the underlying security. The value of delta ranges from -100 to 0 for puts and 0 to 100 for calls (multiplied by 100 to shift the decimal). Puts generate negative delta because they have a negative relationship to the underlying i.e. put premiums fall when the underlying rises and vice versa.

Conversely, call options have a positive relationship to the price of the underlying: if the underlying rises so does the call premium, provided there are no changes in other variables like implied volatility or time remaining until expiration. And if the price of the underlying falls, the call premium will also decline, provided all other things remain constant.

An at-the-money option has a delta value of approximately 50 (0.5 without the decimal shift), which means the premium will rise or fall by half a point with a one-point move up or down in the underlying. For example, if an at-the-money wheat call option has a delta of 0.5 and wheat rises by 10-cents, the premium on the option will increase by approximately 5 cents (0.5 x 10 = 5), or $250 (each cent in premium is worth $50).

Figure 4: The major "Greeks"

As the option gets further in the money, delta approaches 100 on a call and -100 on a put, with the extremes eliciting a one-for-one relationship between changes in the option price and changes in the price of the underlying. In effect, at delta values of -100 and 100, the option behaves like the underlying in terms of price changes. This occurs with little or no time value, as most of the value of the option is intrinsic. We'll come back to the concept of time value when we discuss theta.

SEE: Going Beyond Simple Delta: Understanding Position Delta

Three things to keep in mind with delta:

1. Delta tends to increase closer to expiration for near or at-the-money options.

2. Delta is further evaluated by gamma, which is a measure of delta's rate of change.

3. Delta can also change in reaction to implied volatility changes.

Gamma, also known as the "first derivative of delta", measures delta's rate of change. Figure 5 shows how much delta changes following a one-point move in the price of the underlying. When call options are deep out of the money, they generally have a small delta because changes in the underlying generate tiny changes in pricing. However, the delta gets larger as the call option gets closer to the money.

Figure 5

In Figure 5, delta is rising as we read the figures from left to right, and it is shown with values for gamma at different levels of the underlying. The column showing profit/loss (P/L) of -200 represents the at-the-money strike of 930, and each column represents a one-point change in the underlying. As you can see, at-the-money gamma is -0.79, which means that for every one-point move of the underlying, delta will increase by exactly 0.79 (for both delta and gamma the decimal has been shifted two digits by multiplying by 100).

If you move right to the next column (which represents a one-point move higher to 931 from 930), you can see that delta is -53.13 (an increase of .79 from -52.34). As you can see, delta rises as this short call option gets into the money, and the negative sign means that the position is losing because it is a short position (in other words, the position delta is negative). Therefore, with a negative delta of -51.34, the position will lose 0.51 (rounded) points in premium with the next one-point rise in the underlying.

SEE: Gamma-Delta Neutral Option Spreads

There are some additional points to keep in mind about gamma:

1. Gamma is smallest for deep out-of-the-money and deep in-the money options.

2. Gamma is highest when the option gets near the money

3. Gamma is positive for long options and negative for short options.

Theta is not used much by traders but it is an important conceptual dimension. Theta measures the rate of decline of time-premium resulting from the passage of time. In other words, an option premium that is not intrinsic value will decline at an increasing rate as expiration nears. Figure 6 shows theta values at different time intervals for an S&P 500 Dec at-the-money call option. The strike price is 930. As you can see, theta increases as expiration gets closer (T+25 is expiration). At T+19, which is six days before expiration, theta has reached 93.3, which in this case tells us that the option is now losing $93.30 per day, up from $45.40 per day at T+0, when we hypothetically opened the position.

Figure 6 : Theta values for short S&P Dec 930 call option

Some additional points about theta to consider when trading:

1. Theta can be very high for out-of-the-money options if they carry a lot of implied volatility.

2. Theta is typically highest for at-the-money options

3. Theta will increase sharply in the last few weeks before expiration and can severely undermine a long option holder's position, especially if implied volatility declines at the same time.

Vega, the fourth and final risk measure, quantifies risk exposure to implied volatility changes. Vega tells us approximately how much an option price will increase or decrease given an increase or decrease in the level of implied volatility. Option sellers benefit from a fall in implied volatility but it's just the reverse for option buyers. In Figure 5, the short call has a negative vega, which indicates the position will gain if implied volatility falls (hence the inverse relationship indicated by the negative sign). The value of vega indicates by how much the position will gain. Using at-the-money vega, which is -96.94, a short call position will gain $96.94.for each 1% drop in implied volatility. Conversely, the position would lose $96.94 in reaction to a 1% rise in implied volatility, . 

SEE: An Option Strategy For Trading Market Bottoms

Additional points to keep in mind regarding vega:

1. Vega can increase or decrease without price changes of the underlying (due to changes in implied volatility).

2. Vega can increase in reaction to quick moves in the underlying. 

3. Vega falls as the option gets closer to expiration.

The price of an option is influenced by changes in the underlying, the time to expiration and implied volatility, as well as how we measure the impact of those variables..