When it comes to trading stock options, traders defer to the Greek language to address risk. Are you familiar with “option Greeks?” In this article, we’ll teach you about the four Greek risk measures of equities options: delta, gamma, theta, and vega.
Delta is the rate of change of a stock option’s price with respect to a change in the underlying stock price. In other words, as stock price changes, the option premium does the same. This relationship is represented as a numerical delta value.
Deltas are assigned to calls and puts as follows:
When the underlying stock of a call option rises, the value of delta increases. Why? Because as a call option’s stock price rises, so does the premium. Delta has a positive correlation with call options and is represented on a scale of 0-1.00. Stock options with higher deltas exhibit a greater sensitivity to fluctuations in stock price.
When the price of the underlying stock falls, the value of a put option rises. Thus, a negative correlation is established. Put deltas are represented on a scale of -1.00 to 0. The lower the put delta, the more sensitive the contract is to stock price fluctuations.
Gamma measures the rate of change exhibited by delta over a period of time. It is a constant value that illustrates the amount of variation in the premium to stock price correlation.
Gamma is used to quantify the relative stability of an option contract’s pricing. For instance, options with high gammas are inherently unpredictable. Conversely, low gammas are sought after because they suggest reduced pricing volatility and a higher probability of expiring at or near current prices.
Generally, gammas are small for contracts that are well out of the money (OTM) or deep in the money (ITM). As a stock option gets near the money, gamma increases.
Theta addresses the options risk posed by time decay. Because options are perishable financial instruments, they lose value as expiration approaches. This occurs because the opportunity to profit from the contract lessens as its time horizon draws to a close.
Functionally, theta quantifies the rate of time decay experienced by an option’s value. Accordingly, theta is always negative for buyers of put and call options. Options writers, in contrast, benefit from theta because their goal is to see the option contract expire worthless.
Theta increases exponentially as contract expiry approaches. For buyers or sellers of stock options, theta is a primary consideration.
Vega is a device used to estimate implied volatility and its potential impact on options pricing. Implied volatility is a term used to describe forthcoming movements in price action.
At its core, vega represents the expectations the market has for volatility in the contract’s underlying stock price. Essentially, calls with higher vegas have a greater chance of trading in the money ahead of expiry, whereas puts with lower vegas are positioned to expire profitably.
As a general rule, vega decreases as a stock option approaches expiry. This is because of a lessened chance of implied volatility swaying an option from ITM to OTM and vice versa.
Stock Options 101: Know Your Risks!
Without a doubt, options are some of the most complex securities on the capital markets. However, many professional traders make a living by trading options and little else. Given their structure, not to mention their flexibility, stock options can help nearly anyone reach their financial objectives.
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