Ready to learn about the metrics used to explain option price moves? In this article, we’ll walk you through the “Greeks,” which are commonly used terms that offer an insight into what options could offer you.
The technical terms, “the Greeks” are used to explain the characteristics of different options. They provide a shorthand breakdown of important aspects of options pricing and behaviour. Learning what they are and how to use them will help you establish which options might suit your trading style.
What are the Greeks in options?
When trading options, the “Greeks” are an essential part of the experience. These metrics offer a window into the option contract’s volatility and potential price changes over time.
There are four major Greeks and a range of minor Greeks as well, but starting with the major Greeks covers most aspects of option pricing methodology. Each of those major Greeks have their own function and, for lack of a better word, personality.
DELTA “The Leader”
This is arguably the most popular Greek. This is because Delta tells you how much the price of an option will change if the underlying stock’s price goes up or down by $1. Think of Delta as the leader of a group.
Let’s look at an example where the price of a call option is $5, the price of the stock is $150, and the Delta is 0.20. If the stock goes up to $151, the option price should increase to $5.20 (Delta + option price = new option price).
Tip: The more an option is out-of-the-money (OTM), the more Delta becomes a negligible metric.
Aside from reading the Delta as the amount of money an option’s price will increase or decrease by, it’s also widely seen as the probability that the option will expire in-the-money. If the Delta is 0.20, the option is seen as having a roughly 20% chance of expiring in-the-money.
The maximum value for Delta is 1.00. It’s worth noting that call options have a positive Delta and put options have a negative Delta. The further in-the-money the option goes, the more Delta it accumulates. For example, an out-of-the-money call option might have a Delta of just 0.30, but a deep in-the-money call may have a Delta of 0.70 — meaning the option is more susceptible to large price swings in the underlying asset price. Conversely, an out-of-the-money put option may have a Delta of -0.30, while an in-the-money put option may have a delta of -0.70.
Tip: Put options have a negative Delta score
GAMMA “The Sidekick”
As Delta’s right-hand man, Gamma focuses on Delta’s expected rate of change. Again, it is probably best explained by using an example, one where Gamma is 0.05 and Delta is 0.20. In this case, traders would expect Delta to increase to 0.25 should the underlying stock price increase by $1.
STOCK PRICE = $150
OPTION PRICE = $5
DELTA = 0.20
GAMMA = 0.05
And then the stock increases by $1…
STOCK PRICE = $151
OPTION PRICE = $5.20
DELTA = 0.25
GAMMA = 0.07
In our example, Gamma changed Delta, which will, in turn, change the price of the option once the stock price increases or decreases.
Gamma is great because it’s a predictor of Delta’s stability. Delta tells you how much the price of the option will change, but how do we know what happens after that $1 fluctuation? Gamma.
Gamma is used by traders to see how stable the option price is when the underlying stock price moves. A Gamma of 0.05 is an indicator of relative stability in terms of the option price.
Tip: Gamma increases when options approach being at the money — ATM — or are approaching their expiry date.
Theta “The Naysayer”
In every group, there’s always that one person who bets against their success — the one always warning about the odds. They are the helpful voice of reason, and in options analysis, Theta is that naysayer.
Theta is almost always a negative number, and it represents how much value the option price is losing with time. For example, a Theta of -0.10 means that your option’s price will decrease by 10 pence every day.
Options sellers love Theta and buyers hate it. Theta is working against you — showing you how much you’re losing every day, so you need to use the other Greeks to determine how much you stand to gain against Theta.
Tip: Theta is time-sensitive and the closer an options contract gets to expiry, the more likely Theta is to increase.
Vega “The Wildcard”
Vega is a bit of an outlier compared to the other three Greeks mentioned, in that it’s directly impacted by a since unmentioned metric. That metric is called Implied Volatility (symbol = σ, aka sigma). All options contracts will contain an implied volatility number. This number is calculated using a complex options pricing model, but it basically illustrates the price swings of the underlying stock. A high implied volatility means the price of the underlying stock is likely to make a sudden swing — either upward or downward. The opposite is also true. A low IV will mean the stock price probably won’t increase or decrease all that much. It’s important to note that probably and likely mean just that — they are not certainties.
Vega estimates how much the price of the options contract will change with each percentage point change of implied volatility. Vega is always a positive number, the equation for using Vega generally looks like this: IV x Vega = Option price change.
For example: XYZ stock’s Implied Volatility increases by 2 and the Vega is 0.2. As a result, the value of the option should theoretically increase by $0.40 (Implied Volatility x Vega).
That’s why Vega is the wildcard of the bunch. They are operating off a different set of rules and measure uncertainty. But this is still a very important metric to look at when judging the potential “success” of an options contract.
Cheat Sheet
| Greek Term | Definition and Uses |
|---|---|
| Delta | Probability that options will expire in-the-money.If a Delta is . 40, it will increase 40 cents if the stock price increases by $1. It is also seen as having a 40% chance of expiring in-the-money. Put options have negative Delta values. The further in-the-money the option is, the more Delta it has. |
| Gamma | Rate of change for Delta. If a Gamma is .05 and Delta is .40, we will expect the next Delta change AFTER the first $1 increase to be an additional 5 cents. It’s a way of predicting the future of Delta. Put options have negative Gamma values, and the lowest/highest they can be is 0. |
| Theta | Rate of decay over time. How much value the option is losing each day it gets closer to the expiry date. |
| Vega | Measure of volatility (or uncertainty). If uncertainty is low, the option is cheaper; if uncertainty is high, the option is more expensive. Implied Volatility almost always increases ahead of an earnings announcement. All options have positive Vega. |
Final thoughts
Once you understand how the Greeks work, you will have established a way to describe and measure the performance and potential of options trades. The Greeks provide a way to use instantly recognisable terms which break down complex elements of the pricing model and help you to get the most out of options trading.
Learn more about the Greeks by visiting the eToro Academy.
FAQs
- Can you short an option?
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It is possible to short options. This is a high-risk proposition usually reserved for very experienced and institutional traders. There is a need to consider a wide degree of risk management criteria, such as ensuring that the underlying asset is being held in case the option holder exercises their right to take ownership of it. For that reason, most retail brokers, including eToro, don’t offer the service to their clients.
- How do the Greeks respond to options being “in-the-money” and “out-of-the-money?”
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The more that an option is out-of-the- money, the less likely it is to change in price if there is a move in the price of the underlying asset. A 5% change in price in the underlying asset may itself be significant, particularly if you are holding a position in it, but if your option is very far out-of-the-money, there is still only a limited chance of the option becoming profitable before the expiry date. Option prices become more responsive when the strike price and current stock price converge.
- What is the Black-Scholes formula?
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The Black-Scholes formula is a mathematical equation which is used to calculate implied volatility. As implied volatility is an important element of the option valuation process, the Black-Scholes model plays a crucial part in determining the fair value of options.
All examples used in this article are hypothetical and meant for educational purposes.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments.
This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Not all of the financial instruments and services referred to are offered by eToro and any references to past performance of a financial instrument, index, or a packaged investment product are not, and should not be taken as, a reliable indicator of future results.
eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.