In our last Foundations of Trading Options blog, we covered the concepts of Intrinsic Value and Time Value and how they function and operate when it comes to trading options. These are essential concepts to understand before we move forward with today's topic. So, if you have not already, you can review our blog on Intrinsic and Time Value here.
There are five variables of option pricing: strike price of the option, price of the underlying security, time until expiration, risk-free interest rate, and implied volatility. However, our analysis of these five variables can go to a deeper level, and to assist this deeper dive, we only need to look at the five Greeks which can be used: Delta, Gamma, Theta, Rho, and Vega.
Delta measures how the price of an option will change when the price of the underlying security increases. This means Delta measures the change in the option price for the subsequent $1 increase in the underlying security. Thus, At the Money call options typically have a Delta of .50, meaning the option will increase in value by $0.50 if the underlying security increases in value by $1. The In the Money call options have Deltas approaching 1.00 while the Out of the Money call options have Deltas approaching 0.00. While, At the Money put options have Deltas of -0.50, In the Money put options Deltas approach -1.00, and finally Out of the Money put Deltas approach -0.00. In short, the Delta will measure how responsive the option is to changes in the price of the underlying asset.
Gamma measures the rate of change of Delta. This particularly means it measures how the Delta of the option will change with the next $1increase in the underlying security. For example, a call option with 0.50 Delta and 0.10 Gamma. The underlying stock moves up $1 per share, and the option value goes up to $0.50. The new Delta is now 0.60, and the next $1 move will add $0.60 to the price of the option contract. Gamma is most effective when used At the Money and decreases as you go further In the Money or Out of the Money. It should be noted, Delta and Gamma aren't accurate beyond the next $1 move of the underlying security because their values change as the underlying security moves.
Think of it like this, imagine a car driving down a long stretch of highway. The location of the car at any time is like the price of an option. In this example, Delta is the velocity of the car, and Gamma is the acceleration of the car. The more the driver accelerates, Gamma, the faster the car moves, Delta, and the faster the car travels. Thus, Gamma is the acceleration factor on the value of an option.
Theta measures the rate of time decay, which means it measures how the option's price will change over the next one day. Theta is always a negative value for options because time only moves forward. Theta is most effective At the Money and approaches zero as you go In the Money or Out of the Money. The only way to benefit from using Theta in your analysis is to be short on your options.
Rho measures the effect of interest rate changes on the option price, which means it measures how the price of the option will change if the risk-free interest rate increases by 100 basis points or 1.00%. Rho is negligible for trading in a low-interest-rate environment but might matter for leaps in a rising interest rate environment. Rho is positive for calls and negative for puts, and it is greatest In the Money and approaches zero the further you go Out of the Money. Rho is small for options that expire soon but greater for long-term options.
Vega measures the effect of implied volatility changes on the option price. Specifically, it measures how the price of the option will change if the implied volatility of the underlying security increases by 1%. Vega is positive for calls and puts, is greatest At the Money, and approaches zero as you go Out of the Money and In the Money. It should be noted that understanding Vega requires a greater understanding of implied volatility which we will cover in next week's option blog.
When applied correctly to your analysis, the Greeks can bring forth a clearer picture of your option trades. However, they can be a little confusing to add to your analysis when you first start dealing with them. So if you have any questions regarding the contents of this blog, please stop by to see our teachers and moderators in our Group Coaching sessions which happen every Thursday. Contact Rebekah at firstname.lastname@example.org for details on Group Coaching sessions. Take care, and we will see you guys back this time next week as we cover implied volatility!