The Greeks are essential to understanding the behavior of options contracts. Without them, trading options contracts would be extremely difficult to execute successfully. Delta, Gamma, Theta and Vega act as your compass when navigating this intricate landscape. Specifically, the Greek letters are used to describe the different variables that influence option pricing. Used strategically for risk management, each Greek letter measures a different factor of price sensitivity in relation to the underlying futures market.
The Greek letter, Delta, measures the rate of change between the price of an option and the underlying contract. Its value ranges from 0 to 100%, and as an option travels further in the money, Delta will approach 100%. This means there is a one-to-one relationship between changes in the option price and movement in the price of the underlying futures contract. For puts, Delta is shown as a negative percentage, whereas calls are shown as a positive percentage. This is due to the behavior of Delta for puts and calls. Puts will increase when the underlying futures goes down, and calls will increase when the underlying goes up.
Delta is the incremental price movement of an option for a one-tick movement in the underlying contract. For example, you buy an Emini S&P Call for 15 points ($750) and operate under the presumption that Delta is 0.50. If the Emini S&P futures moves one point higher ($50), the premium will increase by approximately 0.50 points (0.50 x 1 = 0.50), or $25. Therefore, the price of your original option is now about 15.50 points. The opposite would be true for puts.
Gamma measures the rate of change – acceleration – of Delta, and in this situation, the rate of change in Delta is based on a one-tick change in the underlying contract. Options with the highest Gamma are often the most responsive to movements in the price of the underlying contract. Gamma acts as a prediction of what Delta will be if the underlying asset price moves. This Greek letter is typically at its highest when centered around the at-the-money strike prices, and it reduces when it is further away (deep in the money or out of the money). When looking at Gamma, it is positive for long calls and puts, and negative for short calls and puts. Understanding Gamma allows traders to more accurately predict the movement of an option price and risk, as it measure the movement risk of the underlying asset.
For example, you buy a Crude Oil Call with a Delta of 60% and a Gamma of 0.40%. If the price of crude oil increased from 45.84 to 45.85 (a one-tick increase), the Delta would increase to 60.40%.
Theta measures the impact of time decay on the price of an option. It’s how much value an option contract loses every day as it approaches expiration, and its rate of decay increases as it reaches expiration. Time decay is the enemy of options buyers, and the friend of options sellers. Theta is always shown as a negative number because regardless of what happens to the underlying contract, an option contract is always losing time value. This means that Theta is larger when the strike price is at the money or approaching expiration.
While there is a numerical value associated with Theta, it’s more important to understand it conceptually, rather than mathematically.
The Greek letter, Vega, measures the amount call and put prices will change for every one percent change in implied volatility (IV). It’s important to note that Vega doesn’t have an impact on the intrinsic value of an option’s price, and it only affects the time value of an option’s price. However, implied volatility is the most critical element of an option, as it is the only variable that can’t be predicted. This unknown aspect is what creates opportunity. Since options have a finite lifespan, as the market grows more volatile there is a greater chance the option will be increase in value. The numerical value of Vega is always positive for both calls and puts, as it is looking for a one percent move up.
For example, you bought a December Corn Option for 20.50 cents with a Vega of 1.5 and volatility of 25.90. If the volatility were to increase to 26.90, Vega dictates that the theoretical value would increase by 1.5, to 22 cents.
When trading options, it is important to remember that the Greeks are snapshots in time, as they are constantly adjusting every time the market moves and as the contract approaches expiration. The impact of time decay and volatility have a large influence on the price of an option in addition to the movement of the underlying contract’s price. Due to the complexity of options contracts, working with a professional broker that deeply understands the Greeks, intricate options trading strategies and other price-altering variables is the safest way to trade and reduce risk.