Option Greeks: The 4 Factors to Measure Risk

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Option Greeks: The 4 Factors to Measure Risk
Table 4: The main Greeks
VegaThetaDeltaGamma
Measures Impact of a Change in VolatilityMeasures Impact of a Change in Time RemainingMeasures Impact of a Change in the Price of UnderlyingMeasures the Rate of Change of Delta

Delta

Delta is a measure of the change in an option’s price (or premium) caused by a change in the underlying security. The delta value for puts varies from -100 to 0 and from 0 to 100 for calls (-1.00 and 1.00 without the decimal shift, respectively).Puts create negative delta because they have a negative connection with the underlying security—that is, when the underlying security increases, put premiums decrease, and vice versa.

Call options, on the other hand, have a positive connection with the underlying asset’s price. If the underlying asset’s price rises, so does the call premium, provided that no other factors, such as implied volatility or time before expiry, change. If the underlying asset’s price declines, the call premium will reduce as well, assuming all other variables stay constant.

Consider a racing track to help you visualize delta. The delta is represented by the tires, while the fundamental price is represented by the gas pedal. Low delta choices are analogous to racing vehicles equipped with economical tires. When you accelerate quickly, they won’t acquire any traction. High delta alternatives, on the other hand, are analogous to drag racing tires. When you step on the gas, they generate a lot of traction. Delta values close to 1.00 or -1.00 produce the most traction.

Example of Delta

Assume one out-of-the-money option has a delta of 0.25 and one in-the-money option has a delta of 0.80. A $1 rise in the underlying asset’s price results in a $0.25 increase in the first option and a $0.80 increase in the second. Traders seeking the most traction may wish to choose large deltas, albeit these options are more costly in terms of cost basis since they are more likely to expire in-the-money.

A delta value of around 50 is assigned to an at-the-money option, which means that the option’s strike price and the underlying asset’s price are identical (0.5 without the decimal shift).That implies that a one-point move up or down in the underlying security causes the premium to climb or decrease by half a point.

In another instance, if an at-the-money wheat call option with a delta of 0.5 and wheat increases by $10, the premium on the option will climb by around 5 cents (0.5 x 10 = 5) or $250 (each penny in a premium is worth $50).

Delta shifts when the alternatives become more lucrative or profitable. In-the-money signifies that there is a profit since the option’s strike price is higher than the underlying price. Delta approaches 1.00 on a call and -1.00 on a put as the option moves farther into the money, with the extremes evoking a one-for-one link between changes in the option price and changes in the underlying price.

In terms of price fluctuations, the option reacts similarly to the underlying security at delta values of -1.00 and 1.00. This behavior happens with little or no temporal value since the majority of the option’s value is intrinsic.

Probability of Being Profitable

When assessing the chance of an option being in-the-money at expiry, delta is widely employed. An out-of-the-money call option with a delta of 0.20, for example, has around a 20% probability of being in-the-money at expiry, while a deep-in-the-money call option with a delta of 0.95 has about a 95% chance of being in-the-money at expiration.

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The prices are assumed to have a log-normal distribution, similar to a coin flip.

In general, traders may utilize delta to assess the directional risk of a specific option or options strategy. Higher deltas may be appropriate for more speculative, higher-risk, higher-reward strategies, whilst lower deltas may be perfect for lower-risk, high-win methods.

Delta and Directional Risk

Delta is often used to calculate directional risk. Positive deltas represent long market assumptions (buy), negative deltas represent short market assumptions (sell), and neutral deltas represent neutral market expectations.

When purchasing a call option, you want a positive delta since the price will rise in tandem with the underlying asset price. When purchasing a put option, you want a negative delta, which means that the price will fall if the underlying asset price rises.

Three things to keep in mind with delta:

  1. Delta for near or at-the-money options tends to rise closer to expiry.
  2. Gamma, a measure of delta’s rate of change, is used to further assess delta.
  3. Delta may also alter in response to variations in implied volatility.

Gamma

Gamma is the rate at which delta varies over time. Because delta values fluctuate with the underlying asset’s price, gamma is used to calculate the rate of change and provide traders a sense of what to anticipate in the future. Gamma values are greatest for in-the-money options and lowest for out-of-the-money options.

While delta varies with the underlying asset price, gamma is a constant that indicates delta’s rate of change. As a result, gamma may be used to evaluate the stability of delta, which can be used to predict the chance of an option achieving its strike price at expiry.

Assume two options have the same delta value, but one has a high gamma and the other has a low gamma. The option with the greater gamma will be riskier since a negative change in the underlying asset will have a disproportionate effect. High gamma values indicate that the option is prone to volatility swings, which is undesirable for most traders searching for reliable possibilities.

Gamma may be thought of as a measure of the stability of an option’s likelihood. If delta reflects the likelihood of being in the money at expiry, gamma shows the consistency of that probability across time.

A high gamma option with a 0.75 delta may have a lower probability of expiring in the money than a low gamma option with the same delta.

Example of Gamma

Table 5 demonstrates how much delta changes after a one-point change in the underlying price. When call options are far out of the money, the delta is usually minimal because changes in the underlying create minute changes in price. However, when the call option approaches the money, the delta becomes higher.

Table 5: Example of Delta after a one-point move in the price of the underlying
Strike Price925926927928929930931932933934
P/L42530017550-75-200-325-475-600-750
Delta-48.36-49.16-49.96-50.76-51.55-52.34-53.13-53.92-54.70-55.49
Gamma-0.80-0.80-0.80-0.80-0.79-0.79-0.79-0.79-0.78-0.78
Theta45.0145.1145.2045.2845.3545.4045.4445.4745.4845.48
Vega-96.30-96.49-96.65-96.78-96.87-96.94-96.98-96.99-96.96-96.91

Delta rises as we read the data from left to right in Table 5, and it is presented with gamma values at various levels of the underlying. The -200 column indicates the at-the-money strike of 930, and each column reflects a one-point change in the underlying.

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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. Delta rises as this short call option moves 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.

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

  1. For deep out-of-the-money and deep in-the-money options, Gamma is the smallest.
  2. Gamma is greatest when the option is close to the money.
  3. Gamma is a positive number for long options and a negative number for short options.

Theta

Theta measures the rate of time decay in the value of an option or its premium. Time decay represents the erosion of an option’s value or price due to the passage of time. As time passes, the chance of an option being profitable or in-the-money lessens. Time decay tends to accelerate as the expiration date of an option draws closer because there’s less time left to earn a profit from the trade.

Theta is always negative for a single option since time moves in the same direction. As soon as an option is purchased by a trader, the clock starts ticking, and the value of the option immediately begins to diminish until it expires, worthless, at the predefined expiration date.

Theta is good for sellers and bad for buyers. A good way to visualize it is to imagine an hourglass in which one side is the buyer, and the other is the seller. The buyer must decide whether to exercise the option before time runs out. But in the meantime, the value is flowing from the buyer’s side to the seller’s side of the hourglass. The movement may not be extremely rapid, but it’s a continuous loss of value for the buyer.

Theta values are always negative for long options and will always have a zero time value at expiration since time only moves in one direction, and time runs out when an option expires.

Example of Theta

An option premium that has no intrinsic value will decline at an increasing rate as expiration nears.

Table 6 displays theta values for an S&P 500 Dec at-the-money call option at various time periods. 930 is the strike price.

As you can see, theta rises as the expiry date approaches (T+25 is the expiration date). Theta has hit 93.3 at T+19, or six days before expiry, indicating that the option is now losing $93.30 per day, up from $45.40 per day when the hypothetical trader initiated the position at T+0.

Table 6: Example of Theta values for short S&P Dec 930 call option
T+0T+6 T+13T+19
Theta45.451.8565.293.3

Over time, theta values look smooth and linear, but the slopes for at-the-money options get substantially steeper as the expiry date approaches. Because the possibility of the price hitting the strike price is minimal towards expiry, the extrinsic value or time value of the in- and out-of-the-money options is extremely low.

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In other words, as time passes, the possibility of generating a profit decreases. At-the-money options are more likely to achieve these values and profit, but if they do not, the extrinsic value must be discounted over a short period of time.

Some extra theta considerations for traders:

  1. Out-of-the-money options with a high implied volatility might have a high Theta.
  2. At-the-money options often have the greatest Theta since it takes less time to benefit from a price change in the underlying.
  3. Theta will rise rapidly as time decay increases in the last weeks before expiry, threatening a long option holder’s position, particularly if implied volatility falls at the same time.

Vega

Vega assesses the risk of changes in implied volatility, or the predicted volatility of the underlying asset price in the future. Delta measures actual price movements, while vega represents changes in predictions for future volatility.

Higher volatility makes options more costly since the strike price is more likely to be reached at some time.

Vega informs us how much an option price will rise or fall in response to an increase or reduction in implied volatility. Option sellers profit from a decrease in implied volatility, whereas option purchasers benefit from the opposite.

It’s vital to note that implied volatility reflects options market price activity. When option prices rise as a result of additional buyers, implied volatility rises.

Long option traders gain when prices rise, while short option traders benefit when prices fall. Long options have a positive vega, while short options have a negative vega.

Additional points to keep in mind regarding vega:

  1. Due to fluctuations in implied volatility, Vega may rise or fall independently of the underlying asset’s price.
  2. Vega may rise in response to rapid changes in the underlying asset.
  3. As the option approaches expiry, Vega falls.

Minor Greeks

Options traders may consider additional, more complex risk variables in addition to the major Greek risk elements outlined above. One example is rho(p), which reflects the rate of change in the value of an option in response to a 1% rise in interest rates. This metric evaluates interest rate sensitivity.

Assume a call option with a rho of 0.05 and a price of $1.25 is available. If interest rates climb by 1%, the call option’s value will rise to $1.30, everything else being equal. Put options are the inverse of call options. This is best for at-the-money options with extended expiry dates.

Other minor Greeks that aren’t typically mentioned include lambda, epsilon, vomma, vera, speed, zomma, color, and ultima.

These minor Greeks are pricing model second- or third-derivatives that effect things like the change in delta with a change in volatility, and so on. Because computer software can swiftly calculate and account for these complicated and even esoteric risk characteristics, they are being utilised in options trading methods.

The Bottom Line

The Greeks aid in providing essential assessments of the risks and possible benefits of an option position. Once you’ve mastered the fundamentals, you may start applying them to your present strategy. It is not sufficient to just understand the entire amount at risk in an options position. To understand the likelihood of a transaction generating money, you must be able to calculate a range of risk-exposure metrics.

Because market circumstances are continuously changing, the Greeks allow traders to determine how sensitive a particular deal is to price variations, volatility swings, and the passage of time. Combining a grasp of the Greeks with the tremendous insights provided by risk graphs may take your option trading to the next level.

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