Options premium prices are derived using a mathematical pricing formula based on components calls “Options Greeks”.
Fortunately you don’t have to understand the calculation but it is useful to understand what the various options Greeks are and how to interpret them.
All brokerage platforms with options trading capability automatically calculate the Greeks for you. Therefore, as long as you have a basic understanding of what the various Greeks are and how they work, then you can just reference the Greeks when evaluating trades.
Using Options Greeks
Before getting into what the various Greeks are, it is important to understand that you don’t have to use Greeks to trade options.
The Greeks are used for certain types of options trading strategies, but they can move quite a bit and are based on current data at the moment. Therefore they can move around quite a bit depending on the options you are looking at.
The main option Greeks that traders use are Delta, Gamma, Vega, and Theta. Lets get started :
I wrote about options Delta in a past post with a video, see post: Understanding Options Delta.
Delta measures the sensitivity of an options value to a change in the underlying security.
Delta measures how much the option will move relative to a 1 point move in the underlying security. For example, .50 delta would mean the option will move $0.50cents for each 1 point move in the underlying stock.
Delta is listed as a number between +1.00 and -1.00. Depending on the data source/brokerage platform you use, the delta # might be displayed differently.
Call Options Delta : A call option has a positive delta that is displayed as .01 through 1.00. An at the money call has .50 delta because it essentially means it represents a 50%/50% chance of the stock going up or down since it is right at the money of the current stock price.
The farther in the money an option is then higher the delta will be because it represents a higher likelihood of closing in the money.
Trader Tip : when wanting to trade a big move like an expected oversold bounce at support then buy a farther in the money option with higher delta(and less extrinsic time value) to experience a higher dollar for dollar move with the stock with less volatility premium decay occurring.
New option traders make the mistake of buying an out of the money option or at the money option that is almost all time value premium and therefore not only does the stock not move as much with the underlying stock(<.50 delta), but also experiences volatility(time) value erosion as the stock moves.
Put Options Delta : A put option delta is a value of -1.00 to -.01 The farther in the money that the put option is the larger the delta closer to -1.00. An at the money put option has a delta of right around -.50. which means the option will increase $0.50cents in value for each 1 point drop in the underlying security
Options Gamma moves in related to moves by delta. Gamma measures the amount of change in the delta for each 1 point increase in the underlying security.
Gamma is larger for at the money options and decreases as the options strike price gets farther from the current market price, both for in the money and out of the money options.
Gamma is a positive number both for calls and puts.
Gamma is most relevant when you are trading options near expiration as delta will change quickly for options near the current market price as they move in and out of the money. If you have a a slightly out of the money option you will see gamma increase quickly which can cause large moves in premium near expiration(which is why being short an option near current market prices towards expiration can be dangerous as the premium can move against you quickly).
Some traders use gamma as a trading strategy to scalp moves in gamma but it can usually a more advanced strategy.
Option theta is usually the most popular greek value because it measures time decay in an option which is what options premium sellers are focused on.
Theta is the dollar amount that an option will lose each day from passage of time. For example, a specific option with a theta of value of -.76 means the option will lose $76 of value that day.
(Theta value will change each day based on multiple factors like time to expiration, strike price relative to current market price, volatility of the underlying)
Theta values decrease the farther the option strike price is from the current underlying price due to less volatility that is priced into the option.
Time until expiration is important as theta will be low for farther out expiration periods and you will see slower theta decay until you get close to expiration. For time decay, theta will start to increase rapidly near expiration especially for out of the money options since they have a higher likelihood of expiring worthless.
With theta, it is important to look at how much time value is priced into an option. If the underlying stock is very volatile them a lot of volatility will be priced into the premium and can erode quickly as expiration approaches or volatility decreases.
Trader Tip: If you want to be long an option then the farther out in time you go, the less time theta decay(time erosion you will see) especially for far in the money options.
If you are an option seller looking to collect time decay(theta) then you want to sell shorter term options that are expiring sooner. (Hence why weekly options are growing in popularity among option sellers)
Options Vega measures sensitivity of the price of the options relative to changes in volatility.
An increase in volatility of a stock will cause the options in that stock to also increase in price. A decrease in a stock’s volatility will generally cause a decrease in the option premiums for that stock.
Vega affects both calls and puts but tends to have a higher affect on calls especially on long term options.
It is very important to understand that options premiums reflect the probability of being in/out of the money relative to the stock.
If a stock has high volatility then the options for that stock will have higher premiums because out of the money options have a higher probably change of moving in-the-money if the stock is volatile.
If volatility decreases on a stock then the likelihood of out-of-the-money options becoming in-the-money will also decrease therefore causing the premiums to decrease (even of the stock price doesn’t move).
This is why you will see option premiums jump near earnings seasons on certain stocks and then drop back down after the earnings announcement.
Make sure to pay attention to volatility for any options that you are looking to buy or sell. With all things being equal, you generally want to sell high volatility premium and buy low volatility.
Options Greeks Summary
Overall, it is useful to have an understanding of options Greeks but it really depends on what type of options strategies you are using to decide on how helpful they will be in your options trading.
The keys to understand with options are how volatility, probabilities, and time value affect options.
Make sure you pay attention to the intrinsic vs. extrinsic components of an option you are looking to buy or sell, and then look at the volatility of that underlying options and security to help you see if you are overpaying for that options relative(or if an option is pricing in a big future move like earnings announcement).
Many professional options traders and floor traders use option greeks to manage their positions and options portfolio.
If you are new to options there here is a very low cost popular course to give you all the fundamentals.
Let me know if you have any questions ?
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