The trading market can seem utterly incomprehensible to those that aren’t familiar with the terminology used to describe the various elements involved. Research is key to successful trading, and traders that want to maximise their opportunities will use a variety of resources to help them devise a profitable strategy.
Options traders will often refer to the “Greeks” when discussing their strategy and those that want to understand their role in a trader’s strategy should familiarise themselves with them. But what are the Greeks in options? They are calculations that can be used to assess the direction in which the price of an options contract is likely to move, which is important because option prices aren’t always closely related to the price of the asset they are tied to:
This calculation helps to gauge whether an option is likely to expire while it is in-the-money, meaning that it has an intrinsic value that would allow its owner to buy for less than its market value or sell for more than its current market value. It is often expressed as the degree to which the option price would change based on the underlying security changing by $1.
Delta is usually represented by a number between minus one and one, with the one referring to a loss or gain of a single dollar in value. The sum can also be represented on a scale of minus one hundred to plus one hundred, showing the same thing in terms of the dollar sensitivity you would see if you had an option comprising a hundred shares of the underlying asset.
This helps you calculate the likelihood of your delta values changing as the price of a stock fluctuates. The calculation measures the rate at which the delta will change if the underlying asset’s value increases by a single point.
Gamma is a useful tool when predicting the direction a market is moving in and is used by traders to forecast changes that might affect a position’s delta value. Gamma is measured in positive numbers, with larger values indicating at-the-money options and lower values showing in- and out-of-the-money options.
As options approach their expiry date, they can begin to lose value, and the theta calculation helps ascertain by how much, assuming that everything else stays the same. The erosion of value over time is known as time decay, and it is not normally linear, rather the erosion rate of most options increases as the expiration date approaches.
The volatility of an option is one of the most crucial things for a trader to understand, and the vega calculation is used to determine the rate at which an option’s price changes per percentage point change in the value of the underlying stock.
Although it’s not even a real Greek letter, the vega value is one of the most important in trading as it helps to ensure that you don’t overpay when buying options. If the vega drops, options tend to lose value, whereas if it increases, they gain value, so most traders like to keep an eye on the vega to see whether it’s a good time to buy or sell.
Interest rate changes can have a significant impact on the value of options, so traders use the rho calculation to ascertain what that change would be if the risk-free interest rate set by the US Treasury changes by one percentage point. When interest rates rise, the value of call options will rise as well, whereas decreasing interest rates are usually accompanied by falling put options.
Rho is most useful during periods where there are expected to be significant changes in the interest rates such as before elections or during times of anticipated political upheaval.
In addition to the Greek values, many traders also rely heavily on the implied volatility of an option. This figure is calculated by reviewing historical volatility and using that data to forecast potential movement based on past performance as well as other factors such as upcoming mergers, product launches, or annual earnings reports.
The Greeks are just some of the tools available to traders to help them learn more about how options they hold are likely to perform and to help them choose new investments. It is important to consider a number of factors when deliberating over your next trade, and using historical data showing Greek values over time can be an effective way to predict future movement and plan trades more efficiently.