The greeks are useful metrics that allow us to better understand our position or overall portfolio. By understanding the option greeks, we can determine how the movement in price of the underlying over the duration of a trade will affect the option’s price. Listed below are the four most important greeks (Delta, Gamma, Theta, and Vega).
Delta (Direction) – Rate of change of an option’s price given a $1.00 increase/decrease in the underlying asset price. A positive delta means the option price will increase as the underlying price increases (bullish position). A negative delta means the option price will increase as the underlying price decreases (bearish position). One share of long stock has a delta of 1. To get the delta in terms of stock when trading options, multiply the option delta by 100 (each option covers 100 shares).
Moneyness of an option will affect the option’s delta. For simplicity, let’s look at the effects of moneyness when buying a call option. An ATM options will have a .50 delta. As an option is further OTM the delta approaches 0. As an option is further ITM the delta approaches 1.
Another rule of thumb is that the delta is a good indicator of the probability the option will expire ITM. For example, a long OTM call option with a delta of .40 has around a 40% chance of expiring in the money.
Gamma (Acceleration) – Rate of change of delta given a $1.00 move in the underlying price. For example, we have a long call option with a delta of .65 and the price of the underlying goes up a dollar. After the dollar move, the delta of the call option is .70. The difference in delta is the gamma of the position, which in this scenario is .05.
Essentially, gamma gives an indication of how quickly our delta will change for our position. As options approach expiration gamma increases. An option with a further out expiration (DTE) will have less gamma. With an increase in gamma, the option price will fluctuate up and down faster because the deltas are changing faster.
Gamma is a double edged sword as it becomes larger. A price movement in favor of the trade will improve the price of the option quickly, but at the same time a move in the other direction will have the opposite negative effect.
Theta (Time) – Decay of an option’s price with the passage of one day, all else equal. All else equal meaning if the underlying has no change in either price or implied volatility during a trading day, the next day the value of the option should have decreased by the theta value.
Positive theta is beneficial to sellers as the passage of time devalues the option price. With a decrease in option price, the seller can buy back the option at a lower price netting in a profit. As a buyer of an option, the theta is negative. The hope as a buyer is that the movement in the underlying increases the option price faster than the rate of theta decay working against them.
As options approach expiration the extrinsic value (time value and implied volatility) of an option approaches 0. With the approach of expiration, the time value decay accelerates. At expiration, theta decay will increase for options near ATM (more extrinsic value to decay) while decrease for options OTM (less extrinsic value to decay).
Vega (Volatility) – Rate of change of an option’s price given a 1% change in implied volatility. For example an option with a .20 vega and current price of $2.00 has an increase in implied volatility of 1%. The option now has a value of $2.20.
Buyers of options have a positive vega, while sellers have a negative vega. As implied volatility expands buyers of options benefit as the option prices increase. If implied volatility contracts, sellers benefit as the option prices decrease.
Another important takeaway is that vega gives us a cumulative IV (implied volatility) exposure. As we build a portfolio of different option strategies, the buying and selling of different options gives us a variety of vega values. Looking at the overall positive or negative vega of our portfolio gives us an idea of whether we are long or short implied volatility.