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Option Greeks Definitions, Types and Its Impact on Trading

Published on Wednesday, April 4, 2018 by Chittorgarh.com Team | Modified on Wednesday, July 3, 2019

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What helps you cook tasty food?

Cooking skills?

To a large part but not entirely. The taste of food depends on the quality of ingredients used, balance in the number of ingredients used, the temperature to it is cooked etc. So, even a 5-star chef won't be able to cook a tasty dish if the ingredients are not of good quality and are not used in balanced proportions or if he overcooks it.

Similarly, success in options trading depends on a lot of factors not just the movement of its underlying instrument. It depends on factors like the direction of movement in the market, the speed at which it is moving, the swings in the market and the time until expiration. The factors which influence trading in options are called 'Option Greeks'. There are five Option Greeks:

  • Delta Options
  • Gamma Options
  • Vega Options
  • Theta Options
  • Rho Options

Each of these help a trader to understand the performance of an option under certain scenarios. For example, Delta measures of directional risk while Gamma measures the directional rate of change in the underlying instrument. Vega measures the expected volatility of the underlying while Theta is a measure of the value of time till the expiry of options. Rho measures the change in the value of an option based on movements in the interest rates.

Simply put, option greeks help you measure the different type of risks associated with an option and then take an informed decision on your position- whether to buy, exercise your right or leave the position. Let's understand each of the 'Option Greeks' in detail-

1. Delta Option Greek- Meaning & Importance

It measures the amount by which the price of an option will change for a corresponding 1 point change in the value of the underlying instrument. For example, in case of a stock option, it tells you the change in the premium price of an option to 1 point change in the value of a stock. Say you buy Infosys Option when its share price was Rs 2500. After the purchase, it moved up to Rs 2550. Now the price of its option will not increase by 50 points. That's where delta of an option comes into the picture. It tells you by how much the premium of an option will increase for corresponding movements in the underlying instrument.

Deltas are expressed as decimal points. Delta on calls are expressed as positive numbers between 0 and 1, while Deltas on puts are expressed as negative numbers between 0 and -1.

How knowing Delta helps you as an option trader?

  • Delta informs you about how your option position will be impacted by price movements in the underlying instrument.
  • It tells you about the profitability of an option position e.g. an in -the -money option with higher delta would deliver more profits than an in-the-money option with a lower delta.
  • Delta tells you about the likelihood of your option staying in in-the-money. A higher delta means a higher probability of your option staying in-the-money and the probability decreases as your delta value gets lower. So an option with a delta of 1.0 has 100% probability of staying in-the-money while that with 0.25 Delta has 25% chances.
  • It helps you take calculated risks based on delta value.

2. Gamma Option Greek- Meaning & Importance

Delta measures how a 1 point change in the value of an underlying instrument will result in the corresponding change in the premium of an option. Gamma measures the rate of change of delta for a 1 point change in the value of an underlying instrument. So delta measures the change in price whereas Gamma measures the speed of change in delta.

Gammas are expressed as a decimal point with a range of 0 to 1. It can be negative and positive.

How knowing Gamma helps you as an options trader?

  • Gamma is helpful for you if you are taking short and long positions in an option contract.
  • It is also helpful in deploying advanced option strategies.

3. Theta Options Greek- Meaning & Importance

Time is an enemy in options trade. Options are heavily dependent on their life to expiry. Theta is a measure of loss in value due to the passage of time to an option's position. It tells you by how much your option losses with the passing of 1 day. Say an option has a premium of 10 and theta of 0.05. So, the 1st day it will decline to 9.95 (10-0.05), the next day to 9.90 and so on.

Theta starts with virtually a zero and begins to accelerate, particularly in the last weeks of expiry.

How knowing Theta helps you as an options trader?

Theta is highly helpful for deploying advanced strategies especially income strategies.

4. Vega Options Greek- Meaning & Importance

Vega measures the change in the premium of an option with every percentage point change in volatility of the underlying instrument. High volatility options trade at higher premiums than low

volatility ones. Vega tells you by how much the option price will move up or down as the volatility fluctuates.

For example, say an option's underlying instrument has a volatility factor of 40% and the current premium is 100, a vega of .10 would mean that the premium will increase to 100.10 if the volatility increases by 1% to 41%.

How knowing Vega helps you as an options trader?

Vega is not correlated to Delta and Gamma. And that's why it is used by traders to build option positions that are delta and gamma neutral. In such positions, profits are dependent on the probable increase or decrease in volatility.

5. Rho Options Greek- Meaning & Importance

Rho measures the expected change in an option's value for a 1 per cent change in the interest rates. Rho is one of the least used greeks because options are mostly traded for reasonably short time horizons and interest rates don't often change during such periods.

How knowing Rho helps you as an options trader?

As said, Rho is not generally used in trading. However, the increase in interest rates increases call prices and decreases put prices and vice versa.

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