Options traders often refer to the delta, gamma, vega, and theta of their position as the "Greeks."
Option Greeks are a way to measure an option's sensitivity to ever-changing external factors. Their values are dynamic and will fluctuate as price and information changes.
There are many elements to an option’s price. Time until expiration, implied volatility, changes in the underlying asset’s price, and interest rates all impact the value of an option. There are five main option Greeks, and each relates to either the option’s intrinsic or extrinsic value.
Delta and gamma are dependent on the option’s spot and strike price and relate to intrinsic value. Theta, vega, and rho are determined by time to maturity, volatility, and interest rates, all of which are components of extrinsic value.
Delta is the amount an options price should change based on a $1 move up in the stock.
Calls have a positive delta between 0 and 1, while puts have a negative delta between 0 and -1. Delta would represent the number of relative shares you would own if you purchased an option at a specific delta. Buying a call option with a .50 delta is roughly equivalent to owning 50 shares of stock (and vice versa with put options: -.50 delta is the same as shorting 50 shares).
For example, a stock priced at $100 has a $110 call option expiring in 60 days with a delta of .30 and costs $2.00. If the underlying stock moves up to $101, the option should now be worth $2.30. Owning 100 shares of the stock would have realized a gain of $100. The .30 delta option realized approximately 30 shares worth of value, or $30. Delta can also act as an approximation of the probability an option will finish in-the-money. A .30 delta has roughly a 30% chance of expiring in-the-money (or a 70% chance of expiring out-of-the-money).
Gamma is closely related to delta. Gamma is the rate of change in delta for every $1 change in the underlying price. Gamma represents the acceleration at which an option's price increases or decreases. Think of gamma as the next dollar move.
For example, if an option has a delta of .40 and a gamma of .20, the first dollar move in the underlying asset will see the price of the option change by $0.40 ($40). The subsequent dollar move of the stock will see the price of the option change another $0.40 ($40) plus an additional $0.20 ($20). Therefore, a $2 move in stock price will result in a total net change of $1.00 ($100) in the option’s price.
Gamma is higher for contracts closer to at-the-money and more sensitive to changes in the underlying asset price. Gamma risk is the concern that price changes in the underlying asset will have an adverse impact on the option premium. Gamma risk increases as options approach expiration because a small move in the underlying security will significantly impact pricing due to the lack of time remaining on the contract.
Theta represents the effect time decay has on the value of an option. Options are a decaying asset. Options contracts lose value daily from the passage of time. The rate at which options contracts lose value increases exponentially as options approach expiration. Theta is the amount the price of the option will decrease each day. For example, a theta value of -.02 means the option will lose $0.02 ($2) per day.
Theta is always represented in negative terms because the portion of an option’s value related to time is always going down. Theta value is smaller further away from expiration and is not constant -- it accelerates more rapidly the closer it gets to expiration. Theta is an advantage for the option seller and a disadvantage for the option buyer.
Vega is the amount option prices change for every 1% change in implied volatility in the underlying security. Vega represents an unknown element because future volatility cannot be predicted. All other components of an option’s price can be determined objectively: spot price, strike price, and time to expiration. Vega has no impact on the intrinsic value of an option. It is not based on price movement in the stock, only changes in volatility. As volatility increases, an option’s price increases as market participants anticipate an above-average move may be possible before expiration. Vega decreases as it approaches expiration because there is less time for volatility to occur.
Rho measures the sensitivity of an option’s price as it relates to changes in interest rates. Rho represents the expected change of a contract’s value for a 1% change in interest rates. Rho is not as important for short-term options traders because changes in interest rates are usually relatively small, and only adjusted once per quarter, if at all.
Long-term options, or LEAPS, are more significantly impacted by changes in interest rates because of their long expiration period. Investors hedging long-term positions with options may also consider rho, as changes in interest rates will affect the value of those positions.