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Option Greek - The Option Guide

Option Greek - The Option Guide

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Published by PINAL
Delta, Gamma, Vega, Theta, Rho, Gtreek letters, Call optins, Put options, derivatives, risk management
Delta, Gamma, Vega, Theta, Rho, Gtreek letters, Call optins, Put options, derivatives, risk management

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Categories:Business/Law, Finance
Published by: PINAL on Jan 13, 2010
Copyright:Attribution Non-commercial

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05/15/2012

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In options trading, you may notice the use of certain greek alphabets when describing risks associated withvarious positions. They are known as "the greeks" and here, in this article, we shall discuss the four mostcommonly used ones. They are delta, gamma, theta and vega.
1.
Delta
- Measures the exposure of option price to movement of underlying stock price
o
o
o
2.
Gamma
- Measures the exposure of the option delta to the movement of the underlying stock price
o
o
o
3.
Theta
- Measures the exposure of the option price to the passage of time
o
o
o
4.
Vega
- Measures the exposure of the option price to changes in volatility of the underlying
o
o
Delta
The option's delta is the rate of change of the price of the option with respect to its
price. The delta of an option ranges in value from 0 to 1 for 
(0 to -1 for 
 
) and reflectsthe increase or decrease in the price of the option in response to a 1 point movement of the underlying assetprice.
 options have delta values close to 0 while
 options have deltasthat 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 morepractical to know the up delta and down delta values. For instance, the price of a call option with delta of 0.5may increase by 0.6 point on a 1 point increase in the underlying stock price but decrease by only 0.4 pointwhen the underlying stock price goes down by 1 point. In this case, the up delta is 0.6 and the down delta is0.4.
Passage of time and its effects on the delta
As the time remaining to expiration grows shorter, the
of the option evaporates andcorrespondingly, the
of  
increases while the delta of 
decreases.
 
The chart above illustrates the behaviour of the delta of options at various strikes expiring in 3 months, 6months and 9 months when the stock is currently trading at $50.
Changes in volatility and its effect on the delta
As volatility rises, the 
of the option goes up and this causes the 
 of 
options to increase and the delta of 
 options to decrease.The chart above depicts the relationship between the option's delta and the volatility of the
 which is trading at $50 a share.
Next:
 
Gamma
The option's gamma is a measure of the rate of change of its
delta
. The gamma of an option is expressedas a percentage and reflects the change in the delta in response to a one point movement of the underlyingstock price.Like the delta, the gamma is constantly changing, even with tiny movements of the underlying stock price. Itgenerally is at its peak value when the stock price is near the
strike price
of the option and decreases asthe option goes deeper into or out of the money. Options that are very deeply into or out of the money havegamma 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'sassume 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  
options increases while the
 of 
 and 
options decreases.The chart above depicts the behaviour of the gamma of options at various strikes expiring in 3 months, 6months 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
 of 
 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
of such options are low but it goes up dramatically as the underlying stock price approaches the
. 

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