If you knowledge of the Greeks is limited to Plato or Alexander the Great, you may want to brush up on your history. And if your knowledge of Socrates comes entirely from watching “Bill and Ted’s Excellent Adventure,” there may be some deep problems.
But if you find yourself lacking in when it comes to knowledge about the Greeks in the stock market, you’ll have plenty of company. Maybe you’ve seen those columns at the top of an options chain and wondered exactly what they mean and what they do. If so, join the club. There are a lot of people who don’t know and don’t ask. And by doing that, they are short-changing themselves. There is very much to be gained by learning what these Greeks mean and how they can affect your trading.
The Greeks measure sensitivity of option pricing to four factors of the pricing model:
- Changes in a stock price is measured by delta and gamma
- Changes in time is measured by theta
- Changes in volatility is measured by vega
- Changes in interest rates is measure by rho
The most commonly used Greek is delta. You probably learned about delta and how it affects and option price in one of your early education classes.
Delta is affected by movement in the price of the underlying stock. Delta is also affected by the time to expiration. Delta can be affected by implied volatility.
Call options have positive delta and put options have negative delta. Intrinsic value always trades with a 1 delta.
As expiration day approaches, the delta changes. In-the-money delta moves toward 1.00 (the gamma increases). Out-of-the-money delta moves toward 0.00 (the gamma decreases)
- GAMMA is displayed as the projected change in the DELTA given a $1 move in the underlying stock.
- GAMMA is also affected by time to expiration.
- The less time to expiration, the more pronounced the GAMMA
- Time is a diminishing resource.
- As expiration approaches, there is less time left.
- The price of an option can include “time value”.
- The time value component of an option price is reduced as expiration approaches.
- This time value “decay” is represented by the THETA.
- THETA can be affected by the IMPLIED VOLATILITY.
- THETA is the measure of an options price “sensitivity” to diminishing time.
- THETA only affects the “TIME VALUE” portion of an options price.
- At expiration, there is no more time left, hence there is no “TIME VALUE”
- Because there is no “TIME VALUE”, all OTM options have expired worthless.
- THETA increases as expiration approaches.
- VEGA measures the option price sensitivity to a move in Implied Volatility.
- It represents how much the option price will change based on a 1% change in Implied Volatility.
While this is a very simplified version of the option Greeks, it is a solid start to helping understand how option pricing works.