Introduction to Option Greeks
Options trading offers many strategies and ways to profit from different market conditions. To assess which option strategy is suitable, you must consider the risks involved in each strategy. Option traders typically refer to the following risk measurements: Delta, Gamma, Theta, Vega and Rho, which are referred to as the option "Greeks". They are a set of risk measures that describe how the price of an option moves to various factors.
In this article, we will break down the five main Greeks and show you how they work and how you can use them to improve your options trading strategy.
The Greeks are calculated using high-level mathematics and the Black-Scholes option pricing model. The Greeks' computation is available on broker trading platforms, quote screen providers, financial news portals or option analytics software programs. There are also online calculators available on Exchanges, such as the Chicago Board Options Exchange (CBOE) where you can try various inputs of option data to calculate the Greeks.
Delta
Delta measures the change in the price (premium) of an option relative to the change in the underlying asset. The Delta for a call option is positive, meaning the option's price will go up if the underlying asset's price goes up; whereas the
Delta for a put option is negative, meaning the option's price will go down if the underlying asset's price goes up.
Say you own a call option on Crude Palm Oil Futures (OCPO), which is currently priced at RM100. If your call option has a Delta of 0.5, it means for every RM1 that the Crude Palm Oil Futures (FCPO) price goes up, your option will increase in value by RM 0.50. Conversely, if the FCPO price drops by RM1, your option will lose RM 0.50 in value.
Delta values range between 0 and 1 for calls and 0 and minus 1 for puts. When the option's strike price is close or at-the-money, the delta of the option will be around 0.5 for long call options and -0.5 for long put options. The closer Delta is to 1 (or -1), the more the option behaves like the underlying asset, meaning it is more "in the money."
Gamma
Gamma measures how fast the delta of the option changes for every 1-pointmove in the underlying asset. Gamma is otherwise referred to by some traders as the delta of the Delta; in other words, it measures the acceleration of Delta. Gamma differs from Delta as it is always expressed as a positive number.
Let's continue with the OCPO example. If your call option has a Gamma of 0.1, and the FCPO price increases by RM1, your Delta will increase by 0.1. So, if your Delta were 0.5 before, it would now become 0.6 after the FCPO moves by RM1.
Gamma is the largest for at-the-money options. This means that the Deltas for at-the-money options are more sensitive to a change in the underlying asset's price.
Theta
The Theta of an option is a measure of the time decay of an option. Theta tells you how much value an option loses in a day as it gets closer to the expiration date. Since options have a limited lifespan, the less time an option has until expiration, the faster the option will lose value since there is less time for the underlying asset to move in your favour.
Theta is always expressed in the negative. For example, an option, whether a call or put with a Theta of minus 0.50 will lose RM 0.50 per day.
Vega
Vega tells us how much the option's price will change for every 1 per cent change in implied volatility. Vega helps you gauge how much the option price could change based on the level of uncertainty or volatility in the market.
Say, if you purchased the OCPO option for RM100 and its Vega is 0.2, we can expect the cost of the option to increase by RM20 when implied volatility moves up by 1 per cent. Higher volatility usually increases option prices because there is a greater chance the option will move "in the money." Vega is typically highest for at-the-money options.
Note that Vega is not correlated with the changes in underlying asset prices. It is solely influenced by implied volatility.
Rho
Rho measures how much the option's price will change if the interest rate changes by 1%. This Greek is not commonly discussed as the interest rate changes tend to be gradual, although it can still affect pricing for longer-term options. If your options have a Rho of 0.05, it means that for every 1% increase in interest rates, the value of your option will increase by RM 0.05. Rho is more relevant for call options than put options.
Combining The Greeks
In real-life trading, options traders look at how Delta, Gamma, Theta, Vega, and Rho interact with each other to form a complete picture of their position's risk and reward. Below is an example of how the combined Greeks affect the option's price as market conditions change.
Assume a hypothetical call option on stock ABCD with the following details:
Underlying ABCD Stock Price: RM 100.00
Strike Price: RM100.00 (at-the-money, ATM)
Time to Expiration: 30 days
Volatility: 20%
Interest Rate: 3%
Option Greeks for your option:
Delta = 0.50
Gamma = 0.05
Theta = -0.03
Vega = 0.10
Rho = 0.01
Say the current premium/ price of the option is RM 4.50.
If the next day:
Price of ABCD increases by RM1.00,
Volatility increases by 1% and
Interest rates increase 1%;
Since Delta is 0.50, the price of the option will increase by RM 0.50; However, Gamma is, 0.05, so the Delta is increased by 0.05. New Delta is 0.50 + 0.05, equivalent to 0.55.
We can take the average of RM0.50 and RM0.55 = RM0.525 for the impact on the premium price.
The combined Greeks will affect the price of ABCD as follows: -
Initial price of option: RM 4.50
Stock ABDC Price Increases by RM 1 (Delta + Gamma): New price = 4.50 + 0.525 = RM 5.025
One day passes Theta: New price 5.025 – 0.03 =RM4.995
Volatility increase: New price 4.995 + 0.10 = RM 5.095
Interest rate increase: New price 5.095 + 0.01 = RM 5.105
Final option price after all factors: RM 5.10 (rounded)
By learning to use Delta, Gamma, Theta, Vega, and Rho in combination, you can better manage your risk and improve your options trading. Check out the various online option calculators to familiarize yourself with how the Greeks influence the price of options.
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