Yet another way to view delta is from a net position on the underlying security. This shows that in terms of profitability, nearer term options are more profitable as they are cheaper and has a higher delta but also carries more risk as it allows less time for the underlying stock to move in your favor.
What Are Option Greeks?
Theta is a measure of the time decay of an option, the dollar amount an option will lose each day due to the passage of time. For at-the-money options, theta increases as an option approaches the expiration date. For in- and out-of-the-money options, theta decreases as an option approaches expiration. The further out in time you go, the smaller the time decay will be for an option. If you want to own an option, it is advantageous to purchase longer-term contracts. If you want a strategy that profits from time decay, you will want to short the shorter-term options, so the loss in value due to time happens quickly.
Theta Risk and Reward. The final Greek we will look at is vega. Many people confuse vega and volatility. Volatility measures fluctuations in the underlying asset. Vega measures the sensitivity of the price of an option to changes in volatility. A change in volatility will affect both calls and puts the same way. An increase in volatility will increase the prices of all the options on an asset, and a decrease in volatility causes all the options to decrease in value.
However, each individual option has its own vega and will react to volatility changes a bit differently. The impact of volatility changes is greater for at-the-money options than it is for the in- or out-of-the-money options. While vega affects calls and puts similarly, it does seem to affect calls more than puts. Perhaps because of the anticipation of market growth over time, this effect is more pronounced for longer-term options like LEAPS.
In addition to getting the Greeks on individual options, you can also get them for positions that combine multiple options. This can help you quantify the various risks of every trade you consider, no matter how complex. Since option positions have a variety of risk exposures, and these risks vary dramatically over time and with market movements, it is important to have an easy way to understand them.
The Greeks let you see how sensitive the position is to changes in the stock price, volatility and time. The Greeks help to provide important measurements of an option position's risks and potential rewards. Once you have a clear understanding of the basics, you can begin to apply this to your current strategies.
It is not enough to just know the total capital at risk in an options position. To understand the probability of a trade making money, it is essential to be able to determine a variety of risk-exposure measurements. Since conditions are constantly changing, the Greeks provide traders with a means of determining how sensitive a specific trade is to price fluctuations, volatility fluctuations, and the passage of time.
Combining an understanding of the Greeks with the powerful insights the risk graphs provide can help you take your options trading to another level. For further reading, see: Getting to Know the Greeks. Finding Values for the Greeks First, you should understand the numbers given for each of the Greeks are strictly theoretical.
As the Underlying Stock Price Changes—Delta and Gamma Delta measures the sensitivity of an option's theoretical value to a change in the price of the underlying asset. Changes in Volatility and the Passage of Time—Theta and Vega Theta is a measure of the time decay of an option, the dollar amount an option will lose each day due to the passage of time. Using the Greeks to Understand Combination Trades In addition to getting the Greeks on individual options, you can also get them for positions that combine multiple options.
The Bottom Line The Greeks help to provide important measurements of an option position's risks and potential rewards. In fact, many trading programs perform this calculation for you and it can be found in your Fidelity options trading platform for individual contracts. How might a trader interpret delta? There are actually a few different ways to use it.
For each dollar move in the underlying asset, the option price would approximately move by the delta. The delta for a put works similarly, but would be a negative number; as the price of the underlying asset decreases in value, the price of the option increases. Many traders use delta in other ways as well. Yet another way to view delta is from a net position on the underlying security.
For instance, if a trader holds a call contract with a delta of 0. Similarly, holding a put option or shorting a call, with a net delta of —0. Of course, the option value implied by delta is not an exact science. Delta simply implies a theoretical value. Factors will influence the price of an option beyond the price of the underlying asset.
Still, delta does serve as a very useful guide, depicting how sensitive to the underlying asset an option might be. Learning how to use delta as part of your options trading is important. You can learn a lot about how an option trades by observing Greeks, such as delta, for specific contracts over time. Here are some helpful guidelines to get you started:. Gamma —This Greek is directly related to delta. Whereas delta will change based on a price move in the underlying asset, gamma is the rate of change, or sensitivity, to a price change in the underlying for delta.
Basically, gamma measures how well delta describes an option's sensitivity. Positive gamma accelerates gains and decelerates losses on options contracts; this quality can be found in long calls and long puts.
Alternatively, negative gamma decelerates gains and accelerates losses, and is a characteristic of written calls and puts. An increase in the implied volatility i. Vega can be an extremely useful Greek, particularly when volatility is expected to increase or decrease.
Theta —This Greek measures the effect that time's decreasing has on an option as it approaches expiration. This is also known as time decay. Theta quantifies how much value is lost on the option due to the passing of time. It is typically negative for purchased calls and puts, and positive for sold calls and puts.
Note that it is not advisable for inexperienced traders to trade near expiration, as it can be more complex than when there is more time to expiration. Rho —There are several other secondary Greeks that are not as widely used as those listed above. Rho is one such Greek.
It describes an option's sensitivity to a change in interest rates. Note that the relationship between interest rates and option value is not significant. Strictly speaking, an increase in interest rates will increase the value of a call option and decrease the value of a put option. If rates were expected to change dramatically, some traders might incorporate Rho into their analysis. In practical terms, interest rates influence option prices very little.
It can take a little time to learn how to interpret Greeks and to determine which ones you think may or may not be helpful. Learning about Greeks, and how changes in market conditions can affect the price of your options, may help you become a better options trader. Options trading entails significant risk and is not appropriate for all investors.
Certain complex options strategies carry additional risk. Before trading options, please read Characteristics and Risks of Standardized Options.