What are the Greeks doing? Delta, Gamma, Theta and Vega
 

The Greeks are important fundamental components of the price assessment of options before they have reached the expiry date.

The complexity of these can be very severe. We have therefore made a simple compilation of the 4 most used. It's important for investors of options to have an understanding of what can affect the pricing of options contracts that have not yet expired.

The 4 most used Greeks for price changes of options contracts are; delta, gamma, theta, and vega:

Delta = change in price relative to the underlying instrument

Delta thus represents the price change an option contract receives in relation to a 1$ movement in the underlying instrument. Delta measures how price-sensitive an option contract actually is.

 

If an option has a delta value = 0.30, the contract should in theory move 0.30$ for every 1.00$ movement of the underlying instrument.

 

For call options, the delta value goes from 0.00 to 1.00. For put options, the delta value goes from -1.00 to 0.00.

 

The delta of an option contract is also conceivable as to how large a share of the underlying instrument the option represents. For example:  

 

A call option with a delta equal to 0.30 roughly represents around 30 shares of the underlying instrument (an option contract usually has 100 shares of the underlying instrument).

 

You can imagine that the delta also represents the probability of whether a contract will expire ITM (in the money). The same 0.30 delta contract has approx. a 30% probability of going to the expiry date ITM.

Gamma = How fast we get a change in the Delta

Gamma thus represents how fast the delta of an option contract changes. In other words, gamma tells how quickly the price of an option contract changes.

 

Let's take an example:

 

If a call option has a delta equal to 0.30, and the underlying instrument increases 1.00$ in value. Then the delta will no longer be 0.30. Let's say that the delta now is equal to 0.50.

 

The change in delta from 0.30 to 0.50 = 0.20, that's the gamma.

 

Options contracts that are close to the expiration date (expiry) always have a high gamma. This is because the final outcome of an option to expire is ITM (in the money) or OTM (out of the money).

 

High gamma options are considered high-risk options. This is because it is expected that the value of the option will change very much within a short time horizon. High gamma options can be subject to large and extreme price changes. This is why Gamma-Squeeze has become a popular terminology in recent years.

Theta = The time component

This is thus the time component of an option contract. It is based on how much of the value disappears from an options contract over a day while the contract expires. In other words, theta represents how much an option contract will lose in value every day until the expiry date.

 

It is important to note that theta is always a negative value that gradually increases every day towards the expiry date.

 

Theta affects option contracts differently. ATM (at the money) and OTM options will have higher theta values. and thus lose a larger part of the value per. day than an ITM option. This is because theta is not as an important component in the pricing of ITM options as for ATM and OTM options.

 

ITM options are mostly summarized by intrinsic value. Where OTM options have no real value and are mostly summarized by theta.

 

The concept is quite simple. Over a larger time horizon, there is more time for an underlying instrument to move up or down. Thus, there is a greater probability that an OTM option can recover to ITM by the due date, and thus have a real value by the due date. As the expiration date approaches and the time horizon becomes smaller, the probability that the option that is OTM will be able to recover to ITM is considerably reduced and thus the price goes down.

 

 

Vega = Sensitivity to volatility

Although vega is not even a real Greek letter, it's used in options pricing. It measures an options price for each 1% change in implied volatility of the underlying instrument.

A slightly simpler explanation is that vega tells how much an option will move based on changes in implicit volatility.

 

Volatility is probably the most important component behind option pricing, it is very important that investors know what vega is. If the implied volatility of the underlying instrument increases, the value of both put and call options will increase.

 

Volatility is an indicator of uncertainty and how much an underlying instrument can move in both directions. This is exactly why you will see increased pricing in both call and put options if the volatility increases for the specific instrument.  

As you can see, it is a summary of all these Greeks that will make up the price of an option contract at any given time. This can in many cases be a very complex topic. As an options investor, you can make more rational choices about your option strategies, as long as you understand how these components work and how they affect options.

 

You will find good books about options here.

 

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