Changes in Option Value are measured by Six Option Greeks:

I will focus on five out of the six Option Greeks: Delta, Gamma, Theta, Vega and Zeta. The sixth, Rho, has
almost no relevance for active traders.

DELTA: this measures the rate at which the price of the option changes with changes in the underlying
stock (analagous to speed).

For example: If the DELTA of a call option is +50, then as the stock moves up $1.00, the option price will
increase by approximately $0.50.
If the DELTA of a put option is -99, than as the stock moves down $1.00, the put option price will
increase by approximately $0.99.

Why is this important? When choosing options, you want to find those with a reasonably high delta, so
that as the stock moves, the option will rapidly follow suit. If you trade DITM options, you maximise the
leverage of DELTA. Or, you can choose to trade combinations of options that are called DELTA NEUTRAL.
This means that you can balance your trades in such a way that DELTA is effectively zero, in which case
you win whichever way the stock moves (these strategies tend to be low in profit, low in risk, but high in
commissions).

GAMMA: this measures that rate at which DELTA changes (analagous to acceleration).

GAMMA helps a trader measure risk, because a high Gamma means that an option's Delta is very
sensitive to change. Gamma is always high when an option is ATM or NTM (near-the-money), and it is
low for DITM or DOTM (Deep-Out-of-the-Money) options.

GAMMA is really only useful for those who trade Delta Neutral options - if Gamma is high, it means that
the stability of your trade could change any time, and so you need to monitor your position closely.

THETA: This measures the rate at which the price of the option changes over time.

For example: If the THETA of an option is -0.50, then your option value will decrease by approximately
$0.50 every day until the contract expires.

NOTE: The closer you are to expiration, the more the THETA grows - the price of the option decreases at
an increasing rate over time.

Why is this important? If you BUY calls or puts, THETA or TIME DECAY becomes your enemy. If THETA is
high, you must plan to not hold on to the option for too long! TIME DECAY will eat up the profits made
from an increase in the stock price.

If you SELL calls, puts or credit spreads, you simply have to hold on to the option, watching as its value
decreases every day until it expires worthless (unless it is ITM), at which point you pocket your profits
and do it again! Selling Options with high Theta means that you will be able to watch the value of an
option decrease rapidly, and become almost valueless, at which point you can buy the option back for
next to nothing, and sell another one. You can see how I do this regularly on my Credit Spreads page.

Time Value can be your ENEMY and EAT your profits;

It can be your FRIEND and earn your profits!

Like delta, theta is also listed on a per share basis within an options chain. If you purchased an option
with a theta of -.45, you would be losing $0.45 per-share per day. Since one option contract controls 100
shares your total loss would come to $45 per contract. When entering negative theta trades such as a
long call option, traders hope to make more money due to a favorable move in the stock price or
volatility than what they lose due to time decay.

Theta increases exponentially as options approach expiration which is why most experienced traders
avoid holding short-term options. On the other hand, when entering positive theta trades traders tend
to sell short-term options to exploit the higher rate of time decay. This is why the majority of option
selling strategies, such as covered calls, naked puts, and calendar spreads involve selling front month
options.

VEGA and ZETA: these two indicators measure the change in an options value relative to changes in
Volatility. VEGA measure the effect of changes in Historical Volatility, and ZETA measure the effect of
changes in Implied Volatility. In both cases, higher volatility means higher options premiums, and
therefore potentially more profit; it also means more risk!

Historical Volatility (measured by VEGA) is a statistical measure of how volatile the stock has been in
recent history. Options with high Vega have experienced high volatility, and therefore could change
price rapidly as the stock price changes. High Vega options are more expensive; low Vega options are
cheaper. VEGA is derived from underlying stock price movement.

Implied Volatility (measured by ZETA) is a measure of the theoretical current value of an option. Using
historical volatility, Theta, stock price, option premium and a few other factors, and theoretical value for
Zeta is calculated. Zeta is derived primarily from market premium of the option itself.

When Vega and Zeta are positive, increased volatility is helping an option position by increasing its
value; when they are negative, increased volatility is hurting the option position (if you are buying calls
and puts).

When Zeta is higher than Vega (i.e. Implied Volatility is higher than Historical Volatility), options prices
could be overvalued, and this is a good time to Sell Options.
When Vega is higher than Zeta, options prices could be undervalued, which may be a good time to Buy
Options. NOTE: it does not always follow that undervalued options will suddenly increase in value; they
may stay undervalued for their whole life span!).
Delta example

Suppose IBM is currently trading at $131, the 125 strike call option has a delta of .80 and the 135 call
option has a delta of .25.  If IBM increases from $131 to $132, the 125 call option should increase in
value by $0.80. The 135 call option should increase in value by $0.25. Because put options decrease in
value as the stock rises, let’s see how the 125 and 135 puts would have fared.  The 125 put has a delta of
-.19 and the 135 put has a delta of -.74. The $1 rise in IBM (from $131 to $132) would have caused the
135 put to decrease in value by $0.74 and the 125 put to decrease in value by $0.19.

Delta

The delta, derived from a theoretical pricing model like Black-Scholes, is a number between 0 and +/-100 that has a
variety of different uses and interpretations including:

 A hedge ratio
 Change in price of an option given a $1 change in the underlying stock
 The probability that an option will finish in-the-money
The table below shows call and put deltas over a range of strike prices. Note that the at-the-money 105 strike has 48
and -52 deltas for calls and puts respectively. Deep in-the-money deltas approach +/-100 while far out-of-the-money
deltas approach 0.

Stock Price: $104

37 days to expiration

Option Delta Option Delta

70 Call 100 70 Put -1
75 Call 97 75 Put -3
80 Call 91 80 Put -9
85 Call 85 85 Put -15
90 Call 78 90 Put -21
95 Call 68 95 Put -32
100 Call 59 100 Put -40
105 Call 48 105 Put -52
110 Call 37 110 Put -63
115 Call 27 115 Put -73
120 Call 18 120 Put -82
125 Call 10 125 Put -90
130 Call 6 130 Put -93
135 Call 2 135 Put -99

Hedge Ratio
Traders who use the delta as a hedge ratio do so to know how many shares of stock to buy or sell in order to
establish a theoretically riskless hedge. By doing so, they are able to establish a position that should make money
regardless of market direction.

Before establishing a hedge, it's important to remember the following:

 The delta of a stock position is always in a 1:1 ratio with the number of shares (in other words, 100 shares of
stock have a 100 delta)
 Calls have a positive delta
 Puts have a negative delta
Position Delta
Long 100 shares of stock + 100
Short 100 shares of stock - 100
Long 1 call (45 delta) + 45
Short 1 call (55 delta) - 55
Long 1 put (70 delta) - 70
Short 1 put (60 delta) + 60

Like other arbitrage strategies, delta neutral strategies are often used to capitalize on price discrepancies in the
market. If the delta of a call option is 45 and the trader wants to stay delta neutral, it will be necessary to sell 45
shares of the underlying stock for every call contract purchased. Similarly, if the calls are sold, stock will have to be
purchased to create a neutral hedge. As the stock price moves, the option delta also changes. For this reason, it may
be necessary to adjust the position by buying or selling stock to remain delta neutral.

Initial Position Delta

Stock Price: $35  
Long 1 40 call 38
Sell 38 shares @ $35 -38
Position Deltas 0

With a stock trading at $35, let's imagine that your theoretical pricing model shows 40 call offered $0.75 below their
theoretical value. Since each contract represents 100 shares, this adds up to a theoretically riskless profit of $75 per
contract. To lock in this profit, you would buy the 40 calls (with a 38 delta) and sell 38 shares of stock for every 40 call
you purchased. In this way, you establish a delta neutral position.

Stock Price: $39

Position Delta
Long 1 40 call 49
Short 38 shares @ $35 -38
Position Deltas +11
Adjustment
Sell 11 shares @ $39 -11
Adjusted Delta 0

Later, if the stock jumps to $39 and the 40 call delta increases to 49, it will be necessary to sell an additional 11
shares of stock to remain delta neutral.

Stock Price: $30

Position Delta
Long 1 40 call + 25
Short 38 shares @ $35 - 38
Short 11 shares @ $39 (from - 11
adjustment)
Delta - 24
 Adjustment  
Buy 24 shares @ $30 + 24
Adjusted Delta 0

If the stock plummets from $39 to $30 and the delta of the 40 call drops to 25, it will be necessary to buy 24 shares
(49 - 25) to remain delta neutral.

Throughout the life of the position, ongoing adjustments may be necessary to maintain the risk neutral position. At
expiration, any out-of-the-money options expire worthless, any in-the-money options are sold (or exercised), and any
long or short stock position is liquidated. At that point, the net result of all the trades should approximate the $75 profit
per contract predicted by the model. This is the essence of how delta neutral trading works.

Now, let's examine how traders use delta to measure the change in price of an option as the underlying moves.

The Delta as a Measure of Changing Option Prices

One of the other common uses of the delta is as a measure of the change in an option's value given a $1 change in
the underlying. For example, imagine that a stock trading at $75 has at the money options with the following prices
and deltas.

Stock Price: $75

Option Price Delta

75 Call $5 + 52
75 Put $ 4.75 - 48

If volatility and all other factors remain the same and the stock price rises to $76, the price of the options will change
by the amount of the deltas. More specifically, the call price will increase by $0.52 and the put price will decrease
(because of the negative delta) by $0.48. Thus, the new option prices will be $5.52 and $4.27 respectively.

It is important to note that the delta of the 75 call and 75 put changes as the stock price moves. If you think in the
case of an large price move, $10 for example, this makes sense. If the 75 put delta didn't change, a $10 price
increase would imply that the put value would drop by $4.80 ($10 per share x -.48) bringing the value to -$0.05. That,
however, is impossible because options never have negative prices. With the stock at $85, the 75 put will be worth
significantly less than $4.75, but it will still have a positive value.

Deep In- and Out-of-the-Money Options

While the deltas of at-the-money options tend to hover near 50, the deltas of deep in- and out-of-money options tend
to approach +/-100 and 0 respectively.

Using the example above, a 50 call might be considered deep in-the-money with the stock at $75. As such, it's value
would consist primarily of its $25 of intrinsic value. For this reason, deep in-the-money options tend to move in
tandem with the underlying stock. For example, a 100 delta option implies a $1 move in the price of the option for
every $1 move in the underlying stock. Therefore, if the stock price dropped from $75 to $73, the 50 call would drop
from $25 to $23.

Deep out-of-the-money options, the 50 put for example, have deltas that approach 0. In other words, since the option
has no intrinsic value and as little as 1/16 of time value, it would take more than a $1 move in the stock to have an
impact on the value of the put. In this case, it might take a $5 drop in the stock price to get the 50 put as high as 1/8.

With these examples in mind, it will be easy to understand the third interpretation that views the delta as a probability.

The Delta as Probability

Although purists might argue that the delta was not intended as a probability, there are many who view the delta as
the likelihood that an option will finish in-the-money.

Consider the following option chain where deltas have been substituted for prices:
Stock Price: $104
37 days to expiration

Option Delta Option Delta

70 Call 100 70 Put -1
75 Call 97 75 Put -3
80 Call 91 80 Put -9
85 Call 85 85 Put -15
90 Call 78 90 Put -21
95 Call 68 95 Put -32
100 Call 59 100 Put -40
105 Call 48 105 Put -52
110 Call 37 110 Put -63
115 Call 27 115 Put -73
120 Call 18 120 Put -82
125 Call 10 125 Put -90
130 Call 6 130 Put -93
135 Call 2 135 Put -99

First, let's look at the at-the-money options. In this case, the closest strike to $104 is the 105 strike. Here, we see that
the 105 calls have a + 48 delta while the 105 puts have a -52 delta. When viewing delta as a probability, it doesn't
matter whether the value is positive or negative. Only the number is important. Thus, the 52 delta of the put can be
interpreted as a 52% probability the option will finish in-the-money. Considering the option is already $1 in-the-money
with the stock at $104, it makes sense that the option would have a slightly better than even chance of finishing in-
the-money. Similarly, the 105 call has a slightly less than even chance of finishing in-the-money. More precisely, the
probability is 48%.

At every strike, the sum of the call and put deltas--all taken as a positive number--add up to approximately 100.

Deep In- and Out-of-the-Money Deltas

Looking at the 135 strike, we see the call and put deltas at 2 and 99 respectively. With the stock at $104, this can be
interpreted to mean there is a 99% probability the 135 put will finish in the money. At the same time, there remains an
outside probability (roughly 2%) the stock will rally above 135 so the 135 calls finish in the money. Not great odds no
matter how you look at it.

How Deltas Behave Closer to Expiration

The closer the options get to expiration, the more the deltas tend to approach 0 and +/-100. Using the example
above, if we fast forward from 37 until expiration to just 9 days, the deltas for each strike are markedly different. For
the sake of comparison, we'll assume the stock price didn't move during the 28 days.

Stock Price: $104

  Days to Expiration Days to Expiration

  37 9 37 9
Option Delta Delta Option Delta Delta
70 Call 100 100 70 Put -1 0
75 Call 97 100 75 Put -3 0
80 Call 91 100 80 Put -9 0
85 Call 85 99 85 Put -15 -1
 90 Call 78 95 90 Put -21 -5
95 Call 68 87 95 Put -32 -13
100 Call 59 71 100 Put -40 -29
105 Call 48 48 105 Put -52 -52
110 Call 37 26 110 Put -63 -74
115 Call 27 10 115 Put -73 -89
120 Call 18 3 120 Put -82 -97
125 Call 10 1 125 Put -90 -99
130 Call 6 0 130 Put -93 -100
135 Call 2 0 135 Put -99 -100

As you can see, the further the option is out-of-the-money, the more its delta approaches 0 or +/- 100. Looking at the
at-the-money 105 strike, we see that the deltas remain exactly the same. However, just one strike away, the 100 calls
gain 12 deltas, while the 100 puts lose 11 deltas. Similarly, the out-of-the-money 110 calls lose 11 deltas. In other
words, with only 9 days remaining until expiration, the probability that the 110 calls would finish in-the-money is only
26%. Just 28 days earlier, the same option had a 37% probability of finishing in-the-money.

A few strikes away, the difference is even more pronounced. The 125 calls which once had a 10% probability of
finishing in-the-money now have only a 1% probability of doing so. Conversely, the 125 put now has a 99%
probability of finishing in the money whereas before the probability was only 90%.

Pin Risk
It sometimes happens that the stock price at expiration is exactly the same as one of the strike prices. In the example
above, if the stock closed at $105 on expiration, the 105 calls and puts would technically have a 50 delta up until the
moment of expiration because the stock's next move, theoretically, has an equal probability of being up or down.

If it becomes apparent the stock will settle on a particular strike price, traders generally get out of the position if they
are short options at the strike because they have no way to know how many contracts on which they will be assigned.
This uncertainty is known as pin risk because they may find themselves unexpectedly short or long if they receive an
assignment notice and the stock moves sharply against them.

Gamma
Although gamma, as a risk measurement, is more useful to professionals who manage large positions, an
understanding of the concept can certainly enhance every investor's knowledge and appreciation of option behavior.

The gamma measures the change in delta of an option as the underlying price changes. Perhaps the best way to
understand this is to look again at the delta across a range of strike prices.

Stock Price: $104

37 days to expiration

Option Delta Option Delta

65 Call 100 65 Put 0
70 Call 100 70 Put -1
75 Call 97 75 Put -3
80 Call 91 80 Put -9
85 Call 85 85 Put -15
 90 Call 78 90 Put -21
95 Call 68 95 Put -32
100 Call 59 100 Put -40
105 Call 48 105 Put -52
110 Call 37 110 Put -63
115 Call 27 115 Put -73
120 Call 18 120 Put -82
125 Call 10 125 Put -90
130 Call 6 130 Put -93
135 Call 2 135 Put -99
140 Call 0 140 Put -100

As you can see in the table above, the deltas range from 0 to +/-100. As the price of the underlying stock changes,
the option deltas also change. The amount these deltas change is referred to as the gamma. More specifically,
gamma is the change in delta for every point change in the underlying.

What is important to notice in the table below in the way gamma increases near the at-the-money strike and
decreases as you get further from the current stock price in either direction. For demonstration purposes only, we'll
assume that the gamma is, on average, 1/5 the difference between the deltas of the 2 strikes.

Stock Price: $104

37 days to expiration

Option Delta Gamma Option Delta Gamma

65 Call 100 0 65 Put 0 0.2
70 Call 100 0.6 70 Put -1 0.4
75 Call 97 1.2 75 Put -3 1.2
80 Call 91 1.2 80 Put -9 1.2
85 Call 85 1.4 85 Put -15 1.2
90 Call 78 2.0 90 Put -21 2.2
95 Call 68 1.8 95 Put -32 2.4
100 Call 59 2.2 100 Put -40 2.4
105 Call 48 2.2 105 Put -52 2.2
110 Call 37 2.0 110 Put -63 2.0
115 Call 27 1.8 115 Put -73 1.8
120 Call 18 1.6 120 Put -82 1.6
125 Call 10 0.8 125 Put -90 1.4
130 Call 6 0.8 130 Put -93 1.2
135 Call 2 0.4 135 Put -99 0.2
140 Call 0 0 140 Put -100 0

Looking at the at-the-money 105 strike, the calls have delta of 48 while the puts have a -52 delta. A gamma of 2.2 for
these options suggests that the delta is going to change by +2.2 for every point increase in the underlying. For
simplicity, we'll round the gamma to 2.0. If the stock moves from $104 to $105, the 105 call and put will have 50 (48 +
2) and -50 (-52 + 2) delta respectively.

Although it might seem confusing that gamma is positive for both calls and puts, it begins to make sense when you
look at the big picture. As the stock price increases, the call deltas increase and approach 100. Meanwhile, the deltas
of the puts also become more positive as the stock price increases. Only this time, because puts have a negative
delta, the more positive the delta, the closer it will be to zero.

How Gamma Behaves Closer to Expiration

Using the example above, if we fast forward from 37 to 9 days before expiration, the deltas and gammas for each
strike are markedly different. For the sake of comparison, we'll assume that the stock price didn't move during the 28
days

Stock Price: $104

  Days to Expiration Days to Expiration

  37 37 9 9 37 37 9 9
Option Delta Gamma Delta Gamma Option Delta Gamma Delta Gamma
65 Call 100 0 100 0 65 Put 0 0.2 0 0
70 Call 100 0.6 100 0 70 Put -1 0.4 0 0
75 Call 97 1.2 100 0 75 Put -3 1.2 0 0
80 Call 91 1.2 100 0.2 80 Put -9 1.2 0 0.2
85 Call 85 1.4 99 0.8 85 Put -15 1.2 -1 0.8
90 Call 78 2.0 95 1.6 90 Put -21 2.2 -5 1.6
95 Call 68 1.8 87 3.2 95 Put -32 2.4 -13 3.2
100 Call 59 2.2 71 4.6 100 Put -40 2.4 -29 4.6
105 Call 48 2.2 48 4.4 105 Put -52 2.2 -52 4.4
110 Call 37 2.0 26 3.2 110 Put -63 2.0 -74 3.0
115 Call 27 1.8 10 1.4 115 Put -73 1.8 -89 1.6
120 Call 18 1.6 3 0.4 120 Put -82 1.6 -97 0.4
125 Call 10 0.8 1 0.2 125 Put -90 1.4 -99 0.2
130 Call 6 0.8 0 0 130 Put -93 1.2 -100 0
135 Call 2 0.4 0 0 135 Put -99 0.2 -100 0
140 Call 0 0 0 0 140 Put -100 0 -100 0

The closer the options get to expiration, the more the deltas tend to approach 0 and +/-100. With 37 days until
expiration, the call deltas ranged from 100 at the 65 strike to 0 at the 140 strike. With 9 days to go, the range is more
concentrated.

It's also worth noting that the real action is happening near the at-the-money strikes. As you can see, the gamma
increases dramatically as the difference between the strike deltas becomes more pronounced.

At the same time at-the-money options rapidly gain gamma, the out-of-the-money options lose it. Just two strikes
away from the at-the-money 105 strike we see the 115 calls and puts losing gamma as expiration nears.

Gamma and the Professional Trader

Seeing how rapidly the delta changes as expiration approaches makes it easier to appreciate just how important it is
for professional traders to carefully monitor their positions. Using gamma to anticipate the change in delta is what
makes it such a valuable measure of risk. Looking at the overall gamma, traders can see at a glance how much
longer or shorter they will be given a move in the underlying stock.

In the discussion on theta or time decay, we make the point that an option position either benefits from the passage
of time or from market movement, but not both. In this sense, gamma is considered the flip side of theta because if
time hurts a position (i.e., negative theta), price movement (i.e., positive gamma) will help it and vice versa. For
example, the short straddle is a position that is hurt by market movement but helped by the passage of time. The
straddle writer wants the market to remain steady because the more the underlying moves, the more likely it is that
the position will lose money. In contrast, a person holding a long straddle is in a race against time hoping to see the
market move before the options expire.
Theta
Theta is the Greek letter used to represent the impact of time on an option's value. All options lose value as they get
closer to expiration. However, the rate at which an individual option loses value is primarily a function of how much
time remains until expiration. Options tend to lose the most value in the final 30 days. At that point, the price decay
accelerates.

Only the extrinsic portion of an option's value is subject to time decay. An in-the-money option will retain at least its
intrinsic value until expiration. In other words, if an underlying stock is trading at $42, the 40 call will always have at
least $2 of intrinsic value whether there are three or 300 days remaining until expiration. Any value above $2 will be
extrinsic value and therefore subject to time decay.

Theta, or time decay, is usually expressed as a negative number to represent the loss of value as time passes. Since
the time remaining on an option can never increase, time decay is a one-way street. Thus, if the theta is given as
-.37, they option will lose $0.37 per day in value.

However, it is important to note that theta changes over time. Assuming the price of the stock doesn't change, an out-
of-the-money $3.50 option with a theta of -.20 will be worth $3.30 tomorrow. At that point, the theta may only be -.18.
If so, the option will only be worth $3.12 the following day if prices remain constant. Gradually, the value of the option
will approach zero as long as it remains out-of-the-money.

In the adjacent table, the theta of the AT&T Aug 35 call is -.10. If the stock price remains unchanged, the Aug 35 calls
will only be worth $1.65 on the following day.

The Relationship Between Theta and Strike Price

When we looked at the extrinsic value of an option in the section on pricing options, we saw that at-the-money
options have the highest extrinsic value. For this reason, these options also have the highest thetas.

Deep in- and out-of-the-money options have lower thetas because they have less extrinsic value than at-the-money
options. The less value they have, they less they can lose through decay. Hence, the lower thetas.

When Time Works For You

The only way to have a positive theta position is to be short options. This makes sense when you consider that short
option positions (e.g., the short straddle) tend to do best in stable markets. Wide swings up or down will hurt these
positions. Only the passage of time will help. Neutral strategies like the long butterfly also benefit from the passage of
time. The less time to expiration, the less chance the underlying stock has to move up or down into unprofitable
territory.

Every option position represents a trade off between time and market movement. You can't benefit from both. If the
passage of time helps a position, price movement will hurt it and vice versa. In Greek terms, price movement, the flip
side of theta, is known as gamma. Any position that has a positive theta (i.e., a position that benefits from the
passage of time) will by definition have a negative gamma. Similarly, a negative theta position (i.e., one that is hurt by
the passage of time), will have a positive gamma.

Rho
Rho is the Greek letter used to represent the impact of the prevailing interest rate on an option's value. More
specifically, the rho measures the change in an option's value given a change in interest rates.

An increase in interest rates raises the carrying costs associated with holding an option position. As such, it
decreases the value of the options. Conversely, a decrease in interest rates increases the value of options. However,
the impact of interest rates on price is so small, relatively speaking, that it makes very little difference overall.
Familiarity with delta, vega, gamma, and theta is much more important because each has a significant measurable
impact on option prices.