Options Greeks: Introduction

Trading options without an understanding of the Greeks - the essential

risk measures and profit/loss guideposts in options strategies - is
synonymous to flying a plane without the ability to read instruments.

Unfortunately, many traders are not option strategy "instrument rated";
that is, they do not know how to read the Greeks when trading. This puts
them at risk of a fatal error, much like a pilot would experience flying in
bad weather without the benefit of a panel of instruments at his or her
disposal.

This tutorial is aimed at getting you instrument rated in options trading,
to continue the analogy with piloting, so that you can handle any strategy
scenario and take the appropriate action to avoid losses or enhance
gains. It will also provide you with the tools necessary to determine the
risk and reward potential before lift off.

When taking an option position or setting up an options strategy, there
will be risk and potential reward from the following areas:


Price change
Changes in volatility
Time value decay
If you are an option buyer, then risk resides in a wrong-way price move,
a fall in implied volatility (IV) and decline in value on the option due to
passage of time. A seller of that option, on the other hand, faces risk with
a wrong-way price move in the opposite direction or a rise in IV, but not
from time value decay. (For background reading, seeReducing Risk With
Options.)

Interest rates, while used in option pricing models, generally don't play a
role in typical strategy designs and outcomes, so they will remain left out
of the discussion at this point. In the next part of this tutorial, the role
interest rates play in option valuation will be touched on in order to
complete the overview of the Greeks.
When any strategy is constructed, there are
associated Delta, Vega and Theta positions, as well as other position
Greeks.

When options are traded outright, or are combined, we can calculate
position Greeks (or net Greeks value) so that we can know how much risk
and potential reward resides in the strategy, whether it is a
long put or call, or a complex strategy like a strangle, butterfly
spreador ratio spread, among many others.

Typically, you should try to match your outlook on a market to the
position Greeks in a strategy so that if your outlook is correct you
capitalize on favorable changes in the strategy at every level of the
Greeks. That is why knowing what the Greeks are telling you is so
important.

Greeks can be incorporated into strategy design at a precise level using
mathematical modeling and sophisticated software. But at a more basic
level, the Greeks can be used as guideposts for where the risks and
rewards can generally be found.

A simple example will help to demonstrate how not knowing the Greeks
can lead to making bad choices when establishing options positions.



If you open any basic options book for beginners, you'll typically find
a calendar spread as an off-the-shelf, plain vanilla approach. If you have
a neutral outlook on a stock or futures market, the calendar spread can
be a good choice for strategists.

However, hidden in the calendar spread is a volatility risk dimension
rarely highlighted in beginner books. If you sell an at-the-money front
month option and buy an at-the-money back month option (standard
calendar spread), the Vega values on these options will net out a positive
position Vega (long volatility).

That means that if implied volatility falls, you will experience a loss,
assuming other things remain the same. What you will find is that a small
change in implied volatility (either up or down) can lead to unrealized
gains or losses, respectively, that make the potential profit from the
original differential time value decay on the calendar spread seem trivial.

Most beginner books regarding calendar spreads only draw your attention
to the positionTheta; this example demonstrates the importance of a
combination of Greeks in any analysis.

When a pilot sees his or her horizon indicator and correctly interprets it,
then it is possible to keep the plane flying level even when flying through
clouds or at night. Likewise, watching Vega and other Greeks can help
keep options strategists from suffering a sudden dive in equity resulting
from not knowing where they are in relation to the risk horizons in
options trading - a dive that they may not be able to pull out of before it
is too late.











Options Greeks: Options and Risk
Parameters

This segment of the options Greeks tutorial will summarize the key
Greeks and their roles in the determination of risk and reward in
options trading. Whether you trade options onfutures or options on
equities and ETFs, these concepts are transferable, so this tutorial will
help all new and experienced options traders get up to speed.

There are five essential Greeks, and a sixth that is sometimes used by
traders.

Delta
Delta for individual options, and position Delta for strategies involving
combinations of positions, are measures of risk from a move of
the underlying price. For example, if you buy an at-the-money call or put,
it will have a Delta of approximately 0.5, meaning that if the underlying
stock price moves 1 point, the option price will change by 0.5 points (all
other things remaining the same). If the price moves up, the call will
increase by 0.5 points and the put will decrease by 0.5 points. While a
0.5 Delta is for options at-the-money, the range of Delta values will run
from 0 to 1.0 (1.0 being a long stock equivalent position) and from -1.0
to 0 for puts (with -1.0 being an equivalent short stock position).

In the next part of this tutorial, this simple concept will be expanded to
include positive and negative position Delta (where individual Deltas of
options are merged in a combinationstrategy) in most of the popular
options strategies.

Vega
When any position is taken in options, not only is there risk from changes
in the underlying but there is risk from changes in implied
volatility. Vega is the measure of that risk. When the underlying changes,
or even if it does not in some cases, implied volatility levels may change.
Whether large or small, any change in the levels of implied volatility will
have an impact on unrealized profit/loss in a strategy. Some strategies
are long volatility and others are short volatility, while some can be
constructed to be neutral volatility. For example, a put that is purchased
is long volatility, which means the value increases when volatility
increases and falls when volatility drops (assuming the underlying price
remains the same). Conversely, a put that is sold (naked) is short
volatility (the position loses value if the volatility increases). When a
strategy is long volatility, it has a positive position Vega value and when
short volatility, its position Vega is negative. When the volatility risk has
been neutralized, position Vega will be neither positive nor negative.

Theta
Theta is a measure of the rate of time premium decay and it is always
negative (leaving position Theta aside for now). Anybody who has
purchased an option knows what Thetais, since it is one of the most
difficult hurdles to surmount for buyers. As soon as you own an option (a
wasting asset), the clock starts ticking, and with each tick the amount of
time value remaining on the option decreases, other things remaining the
same. Owners of these wasting assets take the position because they
believe the underlying stock or futures will make a move quick enough to
put a profit on the option position before the clock has ticked too long. In
other words, Delta beats Theta and the trade can be closed profitably.
When Theta beats Delta, the seller of the option would show gains. This
tug of war between Delta and Theta characterizes the experience of many
traders, whether long (purchasers) or short (sellers) of options.

Gamma
Delta measures the change in price of an option resulting from the
change in the underlying price. However, Delta is not a constant. When
the underlying moves so does the Deltavalue on any option. This rate of
change of Delta resulting from movement of the underlying is known
as Gamma. And Gamma is largest for options that are at-the-money,
while smallest for those options that are deepest in- and out-of-the-
money. Gammas that get too big are risky for traders, but they also hold
potential for large-size gains. Gammascan get very large as expiration
nears, particularly on the last trading day for near-the-money options.


Position
Greeks If Positive Value (+) If Negative Value (-)
Delta Long the Underlying Short the Underlying
Vega Long Volatility (Gains if IV
Rises)
Short Volatility (Gains if IV
Falls)
Theta Gains From Time Value
Decay
Loses From Time Value
Decay
Gamma Net Long Puts/Calls Net Short Puts/Calls
Rho Calls Increase in Value W/
Interest Rates Rise
Put Decrease in Value W/
Interest Rate Rise
Figure 1: Greeks and what they tell us about
potential changes in options valuation

In terms of position Greeks, a strategy can have a positive or negative
value. In subsequent tutorial segments covering each of the Greeks, the
positive and negative position values for each strategy will be identified
and related to potential risk and reward scenarios. Figure 1 presents a
summary of the essential characteristics of the Greeks in terms of what
they tell us about potential changes in options valuation. For example, a
long (positive) Vega position will experience gains from a rise in volatility,
and a short (negative) Delta position will benefit from a decline in the
underlying, other things remaining the same.

Last, by altering ratios of options in a complex strategy (among other
adjustments), a strategist can neutralize risk from the Greeks. However,
there are limitations to such an approach, which will be explored in
subsequent parts of this tutorial. (For more, see Getting To Know The
Greeks.)

Conclusion
A summary of the risk measures known as the Greeks is presented,
noting how each expresses the expected changes in an option's price
resulting from changes in the underlying (Delta), volatility (Vega), time
value decay (Theta), interest rates (Rho) and the rate of change
of Delta (Gamma). It was also shown what it means to have positive or
negative position Greeks.


Options Greeks: Conclusion

Greeks play a critical role in strategy behavior, most importantly in
determining the prospects for success or failure. The key Greek risk
factors - Delta, Vega, and Theta - were explained both in terms of how
each relates to options in general (i.e., What is the sign on the Delta of
all call or put options, or what is sign on the Theta of a call or
putoption?). While Deltas of calls are always positive and Delta of puts
always negative, for the other Greeks the signs for puts and calls are the
same.

Theta is negative for all options because whether puts or calls, each tick
of the clock reduces premium on an option, other things remaining the
same. Likewise, all options have positive Vega values, since regardless of
whether call or put, a rise in volatility will add value, while a decline will
take value away. When moving to the level of position Greeks (i.e.,
Which strategy is employed and which strategy Greeks are associated
with it?), the picture gets more complicated.

Calls and puts can have either negative or positive Greeks depending on
whether or not they are short (sold) or long (purchased). And a
combination of options (calls and puts or different strikes using calls or
puts) will result in a position Delta, Vega or Theta depending on the net
position Greeks in the strategy.

Finally, in the last part of this tutorial, the ceteris paribus assumption (all
things remaining the same) is dropped to look at how Greeks change
when other things don't remain the same, such as implied volatility (IV)
and time remaining to expiration. While just one avenue for exploration,
it was shown how Delta changes with both changes in time remaining
until expiration and falling levels of IV. Further simulations along these
lines could have been carried out, but due to the limitation of space it is
not possible here.

Suffice it to say that a rise in implied volatility will have the reverse
impact in similar magnitudes for calls and puts. As for other scenarios, it
would be best to acquire some software or access to a
sophisticated broker platform that allows for extending this type of
multidimensional analysis to other strategies.



For now, bear in mind that each strategy will be impacted by changing
levels of implied volatility (which can hurt or help depending on the sign
and size of the position Vega), time remaining to expiration
(position Theta risk), and to a smaller extent interest rates (typically
negligible for most short- to medium-term strategies).

With enough practice, eventually an understanding of the relationships of
the Greeks to each strategy will become second nature so that analysis
only becomes necessary to calculate their exact magnitude if using large
lot sizes.

Remember, it is better to trade smart. Begin slowly, risking little, and
eventually increase risk when you begin to achieve success on small
positions.



Wiki
the Greeks are the quantities representing the sensitivity of the price of derivatives such
as options to a change in underlying parameters on which the value of an instrument
or portfolio of financial instruments is dependent. The name is used because the most
common of these sensitivities are often denoted by Greek letters. Collectively these have
also been called the risk sensitivities,
[1]
risk measures
[2]:742
or hedge parameters.
[3]

Use of the Greeks
The Greeks are vital tools in risk management. Each Greek measures the sensitivity of the
value of a portfolio to a small change in a given underlying parameter, so that component
risks may be treated in isolation, and the portfolio rebalanced accordingly to achieve a
desired exposure; see for example delta hedging.
The Greeks in the BlackScholes model are relatively easy to calculate, a desirable
property of financial models, and are very useful for derivatives traders, especially those
who seek to hedge their portfolios from adverse changes in market conditions. For this
reason, those Greeks which are particularly useful for hedging delta, theta, and vega are
well-defined for measuring changes in Price, Time and Volatility. Although rho is a primary
input into the BlackScholes model, the overall impact on the value of an option
corresponding to changes in the risk-free interest rate is generally insignificant and
therefore higher-order derivatives involving the risk-free interest rate are not common.
The most common of the Greeks are the first order
derivatives: Delta, Vega, Theta and Rho as well as Gamma, a second-order derivative of
the value function. The remaining sensitivities in this list are common enough that they have
common names, but this list is by no means exhaustive.
First-order Greeks[edit]
Delta[edit]

Delta,
[4]
, measures the rate of change of option value with respect to changes in the
underlying asset's price. Delta is the first derivative of the value of the option with respect
to the underlying instrument's price .
Practical use[edit]
For a vanilla option, delta will be a number between 0.0 and 1.0 for a long call (or a short
put) and 0.0 and 1.0 for a long put (or a short call); depending on price, a call option
behaves as if one owns 1 share of the underlying stock (if deep in the money), or owns
nothing (if far out of the money), or something in between, and conversely for a put option.
The difference of the delta of a call and the delta of a put at the same strike is close to but
not in general equal to one, but instead is equal to the inverse of the discount factor. Byput
call parity, long a call and short a put equals a forward F, which is linear in the spot S, with
factor the inverse of the discount factor, so the derivative dF/dS is this factor.
These numbers are commonly presented as a percentage of the total number of shares
represented by the option contract(s). This is convenient because the option will
(instantaneously) behave like the number of shares indicated by the delta. For example, if a
portfolio of 100 American call options on XYZ each have a delta of 0.25 (=25%), it will gain
or lose value just like 25 shares of XYZ as the price changes for small price movements.
The sign and percentage are often dropped the sign is implicit in the option type (negative
for put, positive for call) and the percentage is understood. The most commonly quoted are
25 delta put, 50 delta put/50 delta call, and 25 delta call. 50 Delta put and 50 Delta call are
not quite identical, due to spot and forward differing by the discount factor, but they are
often conflated.
Delta is always positive for long calls and negative for long puts (unless they are zero). The
total delta of a complex portfolio of positions on the same underlying asset can be
calculated by simply taking the sum of the deltas for each individual position delta of a
portfolio is linear in the constituents. Since the delta of underlying asset is always 1.0, the
trader could delta-hedge his entire position in the underlying by buying or shorting the
number of shares indicated by the total delta. For example, if the delta of a portfolio of
options in XYZ (expressed as shares of the underlying) is +2.75, the trader would be able to
delta-hedge the portfolio by selling short 2.75 shares of the underlying. This portfolio will
then retain its total value regardless of which direction the price of XYZ moves. (Albeit for
only small movements of the underlying, a short amount of time and not-withstanding
changes in other market conditions such as volatility and the rate of return for a risk-free
investment).
As a proxy for probability[edit]
Main article: Moneyness
The (absolute value of) Delta is close to, but not identical with, the percent moneyness of an
option, i.e., the implied probability that the option will expire in-the-money (if the market
moves under Brownian motion in the risk-neutral measure).
[5]
For this reason some option
traders use the absolute value of delta as an approximation for percent moneyness. For
example, if an out-of-the-money call option has a delta of 0.15, the trader might estimate
that the option has approximately a 15% chance of expiring in-the-money. Similarly, if a put
contract has a delta of 0.25, the trader might expect the option to have a 25% probability
of expiring in-the-money. At-the-money puts and calls have a delta of approximately 0.5 and
0.5 respectively with a slight bias towards higher deltas for ATM calls,
[note 1]
i.e. both have
approximately a 50% chance of expiring in-the-money. The correct, exact calculation for the
probability of an option finishing at a particular price of K is its Dual Delta, which is the first
derivative of option price with respect to strike.
[citation needed]

Relationship between call and put delta[edit]
Given a European call and put option for the same underlying, strike price and time to
maturity, and with no dividend yield, the sum of the absolute values of the delta of each
option will be 1.00 more precisely, the delta of the call (positive) minus the delta of the put
(negative) equals 1. This is due to putcall parity: a long call plus a short put (a call minus a
put) replicates a forward, which has delta equal to 1.
If the value of delta for an option is known, one can compute the value of the delta of the
option of the same strike price, underlying and maturity but opposite right by subtracting 1
from a known call delta or adding 1 to a known put delta.
d(call) d(put) = 1, therefore: d(call) = d(put) + 1 and d(put) = d(call) 1.
For example, if the delta of a call is 0.42 then one can compute the delta of the
corresponding put at the same strike price by 0.42 1 = 0.58. To derive the delta of a call
from a put, one can similarly take 0.58 and add 1 to get 0.42.
Vega[edit]

Vega
[4]
measures sensitivity to volatility. Vega is the derivative of the option value with
respect to the volatility of the underlying asset.
Vega is not the name of any Greek letter. However, the glyph used is the Greek letter nu (
). Presumably the name vega was adopted because the Greek letter nulooked like a
Latin vee, and vega was derived from vee by analogy with how beta, eta, and theta are
pronounced in American English. Another possibility is that it is named after Joseph De La
Vega, famous for Confusion of Confusions, a book about stock markets and which
discusses trading operations that were complex, involving both options and forward
trades.
[6]

The symbol kappa, , is sometimes used (by academics) instead of vega (as is tau ( ) or
capital Lambda ( )
[7]:315
, though these are rare).
Vega is typically expressed as the amount of money per underlying share that the option's
value will gain or lose as volatility rises or falls by 1%.
Vega can be an important Greek to monitor for an option trader, especially in volatile
markets, since the value of some option strategies can be particularly sensitive to changes
in volatility. The value of an option straddle, for example, is extremely dependent on
changes to volatility.
Theta[edit]

Theta,
[4]
, measures the sensitivity of the value of the derivative to the passage of time
(see Option time value): the "time decay."
The mathematical result of the formula for theta (see below) is expressed in value per year.
By convention, it is usual to divide the result by the number of days in a year, to arrive at the
amount of money per share of the underlying that the option loses in one day. Theta is
almost always negative for long calls and puts and positive for short (or written) calls and
puts. An exception is a deep in-the-money European put. The total theta for a portfolio of
options can be determined by summing the thetas for each individual position.
The value of an option can be analysed into two parts: the intrinsic value and the time value.
The intrinsic value is the amount of money you would gain if you exercised the option
immediately, so a call with strike $50 on a stock with price $60 would have intrinsic value of
$10, whereas the corresponding put would have zero intrinsic value. The time value is the
value of having the option of waiting longer before deciding to exercise. Even a deeply out
of the money put will be worth something, as there is some chance the stock price will fall
below the strike before the expiry date. However, as time approaches maturity, there is less
chance of this happening, so the time value of an option is decreasing with time. Thus if you
are long an option you are short theta: your portfolio will lose value with the passage of time
(all other factors held constant).


















Option guide
In options trading, you may notice the use of certain greek alphabets when describing risks associated
with various positions. They are known as "the greeks" and here, in this article, we shall discuss the four
most commonly used ones. They are delta, gamma, theta and vega.
Delta - Measures the exposure of option price to movement of underlying stock price
o What is delta and how to use it
The option's delta is the rate of change of the price of the option with respect to its underlying
security's price. The delta of an option ranges in value from 0 to 1 for calls (0 to -1 for puts) and
reflects the increase or decrease in the price of the option in response to a 1 point movement of the
underlying asset price.
Far out-of-the-money options have delta values close to 0 while deep in-the-money options have
deltas that are close to 1.
Up delta , down delta
As the delta can change even with very tiny movements of the underlying stock price, it may be more
practical to know the up delta and down delta values. For instance, the price of a call option with delta
of 0.5 may increase by 0.6 point on a 1 point increase in the underlying stock price but decrease by
only 0.4 point when the underlying stock price goes down by 1 point. In this case, the up delta is 0.6
and the down delta is 0.4.
Passage of time and its effects on the delta
As the time remaining to expiration grows shorter, the time value of the option evaporates and
correspondingly, the delta of in-the-money options increases while the delta of out-of-the-money
options decreases.

The chart above illustrates the behaviour of the delta of options at various strikes expiring in 3
months, 6 months and 9 months when the stock is currently trading at $50.
Changes in volatility and its effect on the delta
As volatility rises, the time value of the option goes up and this causes the delta of out-of-the-
money options to increase and the delta of in-the-money options to decrease.

The chart above depicts the relationship between the option's delta and the volatility of
the underlying securitywhich is trading at $50 a share.

Gamma - Measures the exposure of the option delta to the movement of the underlying stock
price
The option's gamma is a measure of the rate of change of its delta. The gamma of an option is expressed
as a percentage and reflects the change in the delta in response to a one point movement of the
underlying stock price.
Like the delta, the gamma is constantly changing, even with tiny movements of the underlying stock price.
It generally is at its peak value when the stock price is near the strike price of the option and decreases
as the option goes deeper into or out of the money. Options that are very deeply into or out of the money
have gamma values close to 0.
Example
Suppose for a stock XYZ, currently trading at $47, there is a FEB 50 call option selling for $2 and let's
assume it has a delta of 0.4 and a gamma of 0.1 or 10 percent. If the stock price moves up by $1 to $48,
then the delta will be adjusted upwards by 10 percent from 0.4 to 0.5.
However, if the stock trades downwards by $1 to $46, then the delta will decrease by 10 percent to 0.3.
Passage of time and its effects on the gamma
As the time to expiration draws nearer, the gamma of at-the-money options increases while
the gamma of in-the-money and out-of-the-money options decreases.

The chart above depicts the behaviour of the gamma of options at various strikes expiring in 3 months, 6
months and 9 months when the stock is currently trading at $50.
Changes in volatility and its effects on the gamma
When volatility is low, the gamma of at-the-money options is high while the gamma for deeply into or
out-of-the-money options approaches 0. This phenomenon arises because when volatility is low, the time
value of such options are low but it goes up dramatically as the underlying stock price approaches
the strike price.
When volatility is high, gamma tends to be stable across all strike prices. This is due to the fact that when
volatility is high, the time value of deeply in/out-of-the-money options are already quite substantial. Thus,
the increase in the time value of these options as they go nearer the money will be less dramatic and
hence the low and stable gamma.

The chart above illustrates the relationship between the option's gamma and the volatility of the
underlying security which is trading at $50 a share.

Vega
1. Measures the exposure of the option price to changes in volatility of the underlying
The option's vega is a measure of the impact of changes in the underlying volatility on the option price.
Specifically, the vega of an option expresses the change in the price of the option for every 1% change in
underlying volatility.
Options tend to be more expensive when volatility is higher. Thus, whenever volatility goes up, the price
of the option goes up and when volatility drops, the price of the option will also fall. Therefore, when
calculating the new option price due to volatility changes, we add the vega when volatility goes up but
subtract it when the volatility falls.
Example
A stock XYZ is trading at $46 in May and a JUN 50 call is selling for $2. Let's assume that the vega of the
option is 0.15 and that the underlying volatility is 25%.
If the underlying volatility increased by 1% to 26%, then the price of the option should rise to $2 + 0.15 =
$2.15.
However, if the volatility had gone down by 2% to 23% instead, then the option price should drop to $2 -
(2 x 0.15) = $1.70
Passage of time and its effects on the vega
The more time remaining to option expiration, the higher the vega. This makes sense as time
value makes up a larger proportion of the premium for longer term options and it is the time value that is
sensitive to changes in volatility.

The chart above depicts the behaviour of the vega of options at various strikes expiring in 3 months, 6
months and 9 months when the stock is currently trading at $50.


Theta - Measures the exposure of the option price to the passage of time
The option's theta is a measurement of the option's time decay. The theta measures the rate at which
options lose their value, specifically the time value, as the expiration date draws nearer. Generally
expressed as a negative number, the theta of an option reflects the amount by which the option's value
will decrease every day.
Example
A call option with a current price of $2 and a theta of -0.05 will experience a drop in price of $0.05 per
day. So in two days' time, the price of the option should fall to $1.90.
Passage of time and its effects on the theta
Longer term options have theta of almost 0 as they do not lose value on a daily basis. Theta is higher for
shorter term options, especially at-the-money options. This is pretty obvious as such options have the
highest time value and thus have more premium to lose each day.
Conversely, theta goes up dramatically as options near expiration as time decay is at its greatest during
that period.
Changes in volatility and its effects on the theta
In general, options of high volatility stocks have higher theta than low volatility stocks. This is because
the time value premium on these options are higher and so they have more to lose per day.

The chart above illustrates the relationship between the option's theta and the volatility of the underlying
securitywhich is trading at $50 a share and have 3 months remaining to expiration.