Options Greeks

Trading options without an understanding of the Greeks is like flying a plane without knowing how to read the instruments. You may not have a problem when everything is going smoothly, but you’ll likely end up crashing and burning when any problems arise.

Unfortunately, many options traders are flying blind without a basic understanding of the Greeks – delta, gamma, theta, vega, and rho – or the concepts underlying them. The complex names and mathematical formulas can be off-putting, but in reality, it’s more important to understand what these numbers mean rather than how they are calculated.

This tutorial will help you understand the Greeks and how they can be used to assess the risk and reward potential for any strategy, as well as take the right actions to avoid losses or enhance gains after trades have been placed.

First, What are Options?

An option gives the buyer the right, but not the obligation, to buy or sell an underlying asset at an agreed upon price within a certain period of time. Let’s take a look at how this applies to a concrete example, like buying a house, before looking at financial assets.

Suppose that you’re interested in buying a new house. You have already found the perfect house, but you don’t have the money right now, so you buy an option. The option would let you purchase the house for a set price of $100,000 within a certain time if you choose to do so.

The price that you’re willing to pay for the option would likely depend on many different factors. If housing prices are doubling each year, you would expect to pay a lot more for the option than if prices were relatively flat. Similarly, an option to buy the house within one year would probably be a lot cheaper than the right to buy anytime within the next ten years. These same factors apply when looking at options to purchase financial assets.

Option Pricing

There are three factors that influence the price of an option:

1. Price changes in the underlying asset.
2. Changes in the implied volatility in the underlying asset.
3. Time value decay of the option.

These factors influence option buyers and sellers in different ways:

The influence of these factors on option pricing is summarized using the Greeks, which are fancy words for numerical values that help quantify the risk and reward profile of a given option or option strategy. Options traders use Greeks to quickly and easily understand the complex interplay of these factors in a way that is mathematically exact.

Those familiar with option pricing models – such as the Black-Scholes Model – may note that interest rates play a role in prices. While this tutorial will discuss how interest rates impact calculations, they don’t usually play a role in typical strategy design or outcomes, so they will be left out of the discussion for most parts of this tutorial.

How Greeks Can Help

Many options tutorials use calendar spreads as an introductory strategy. By simultaneously purchasing two options of the same type and strike price with different expirations, options traders with a neutral outlook can profit from a sideways market.

Some of these tutorials will highlight how Theta – a measure of the impact of time decay – impacts the position, but the hidden cost of this strategy actually stems from Vega – a measure of the impact of implied volatility. If you sell an at-the-money front month option and an at-the-money back month option, the Vega value of these options are net long volatility.

This means that a fall in implied volatility will create a loss on the position, assuming everything else remains the same. In fact, small changes in Vega values can have a bigger impact than Theta values. A failure to understand Vega could be extremely costly in these cases, since you might not understand why the option position is losing value.

Looking Ahead

The rest of this tutorial will dive into each of the major Greeks and explain how they can help measure a position’s risk and reward. Then, we will look at the interplay of these Greeks and how they can be used in practice to maximize your odds of success when trading options.

For more background reading, see Using the Greeks to Understand Options