In marketing, you will find no shortage of peculiar terms. These include ‘Bottom of the Funnel’, ‘Cold Calling’, ‘Smarketing’, and many others. One term that gets thrown around in options marketing is ‘trading Greeks.’ This article explains the significance of this term and how it works in the field of options marketing.
What does Trading Greeks mean?
‘Greeks’ is a term in the options market that describes the diverse aspects of risks in an options position. The name stems from the association of risk variables with Greek symbols.
Each risk variable is the outcome of an imperfect assumption or relationship of the option with another latent variable. Traders employ the use of different Greek values to assess options risks, as well as manage option portfolios. The five most common ‘Greeks’ that traders use are Delta, Gamma, Vega, Theta, and Rho. There are numerous others, but we’ll focus on these five in this article.
Greeks encompass a wide array of variables. There are the aforementioned five and many others. Each one has a number associated with it and that number tells traders when the option moves and the option’s risk. The five primary come from a certain calculation system, where each is a first partial derivative of the options pricing model. Basically, the computation uses theoretical means.
For instance, there’s the Black Scholes model, or Black-Scholes-Merton (BSM) model. It’s a model of price variation over time of financial instruments. This includes stocks that can, among other things, aid in determining the price of a European ‘call option.’ Investopedia editor, Will Kenton, writes that:
“The model assumes the price of heavily traded assets follows a geometric Brownian motion with constant drift and volatility. When applied to a stock option, the model incorporates the constant price variation of the stock, the time value of money, the option’s strike price, and the time to the option’s expiry.”
Call & Put options
Before we go any further, let’s first provide context on what ‘call options’, and their ‘put options’ counterparts, are.
Call options are agreements that grant the option buyer the right – not the obligation – to purchase a stock, bond, or commodity. Alternatively, they can buy any other instrument at a specific price within a particular time period. The stock, bond, or commodity is the ‘underlying asset.’ A call buyer will garner a profit when the underlying asset effectively increases in price.
Put options are option contracts. They give the owner the right – not the obligation – to sell a specific amount of an underlying security. This is done at a specific price within a particular time frame. This is the exact opposite of a call option. With that, it gives the holder the right to purchase an underlying security at a specific price. Moreover, this predates the time in which the option expires.
The number or value belonging to a Greek will gradually change over time. Thus, options traders with more experience may calculate these values every day. This is to evaluate any changes that may affect their general positions or outlook. Alternatively, to check if their portfolio needs to go through a rebalance.
There are an array of market factors that can affect the price of an option in some sort of way. Now, assuming all other factors have not gone through any kind of alteration, we can use these models to calculate the Greeks. Moreover, we can determine the impact of each factor when its value experiences a change.
The primary variables
From here, we can move forward in properly explaining each of the five primary Greeks. We’ll start with a basic breakdown of each:
- Delta estimates the likelihood that an option you are considering will expire in the money.
- Theta garners a feel for how much value your option might lose each day the closer it gets to expiration.
- Gamma gauges just how much Delta will change whenever the stock price changes.
- Vega understands the sensitivity of an option to large price swings in the underlying stock.
- Rho simulates the general effect of interest rate changes on an option.
This is representative of the rate of change between the option’s price and a $1 change in the underlying asset’s price. In essence, it’s the price sensitivity of the option that’s relative to the underlying. The Delta of a call option has a range between 0 and 1. Conversely, the Delta of a put option consists of a range between 0 and -1.
Let’s say, for example, an investor has a call option with a Delta of 0.50. Consequently, if the underlying stock increases by $1, the option’s price will theoretically increase by $0.50.
This is representative of the rate of change between the option price and time or time sensitivity. It indicates the general decrease of an option’s price as it gets closer to its expiration. For instance, imagine an investor has an option with a Theta worth -0.50. The option’s prices will go down $0.50 per day, with all else being equal. Following the passage of three trading days, the option’s value will theoretically decrease by $1.50.
Randy Frederick, a writer for the Charles Schwab website, explains that:
“Because time-value erosion is not linear, Theta of at-the-money (ATM), just slightly out-of-the-money and in-the-money (ITM) options generally increases as expiration approaches, while Theta of far out-of-the-money (OOTM) options generally decreases as expiration approaches.”
This is representative of the rate of change between an option’s Delta and the underlying asset’s price. This usually goes by the name of ‘second-order price sensitivity.’ It indicates the total of Delta that changes given a $1 move in the underlying security.
For example, let’s assume an investor has one call option on stock ABC. The call option possesses a Delta of $0.50 and a Gamma of $0.10. So, if stock ABC increases/decreases by $1, the call option’s data will increase/decrease by $0.10.
One easy way to remember this is to apply basic physics to the concept. Delta is the speed and Gamma is the acceleration.
This is representative of the rate of change between an option’s value and the implied volatility of the underlying. This is the option’s general sensitivity to volatility. It indicates the amount an option’s price changes given a $1 change in that volatility. For instance, an option with a Vega worth 0.10 is indicative of the option’s value that may change by $0.10. That is to say if the implied volatility changes by 1%.
By neglecting Vega, you can potentially cause an ‘overpay’ when it comes to buying options. Frederick writes that:
“All other factors being equal, when determining strategy, consider buying options when Vega is below ‘normal’ levels and selling options when Vega is above ‘normal’ levels. One way to determine this is to compare the historical volatility to the implied volatility.”
This is representative of the rate of change between an option’s value and a 1% interest rate change. This measures the general sensitivity to the interest. Let’s assume, for example, a call option’s Rho of $0.05 and a price of $1.25. If interest rates go up by 1%, the call option’s value increases to $1.30, all else being equal. Conversely, the opposite is true for put options.
Rho is, in general, not a very huge factor in the price of an option. However, it should be taken into consideration if prevailing interest rates are going to change. Moreover, if it’s just before a Federal Open Market Committee (FOMC) meeting.
Other (minor) variables
If you recall, there are other Greeks beyond the five primary variables. They don’t get as much discussion but are worth looking into regardless.
These Greeks are second-derivatives or are sometimes third-derivatives of the pricing model. They affect certain things, like the alterations in Delta with a change in Gamma, and so on.