Every Tuesday Chuck releases a new Trader Tip video on YouTube. This week we will discuss Option Greeks: Delta, Gamma, Theta, Vega, and Rho. Watch the Trader Tip Episode for more information!
You can read the episode transcript below or watch the video that follows.
If you have any questions, please reach out to us. We look forward to being a continued part of your trading education!
Today we are going to talk about Option Greeks. When we talked about option Greeks, I like to think of them as actually profit factors, and I think when you think of Greeks in terms of profit factors, it gives you a more clear understanding of the why, why do I even want to know about this?
Why do I even want to learn what Greeks are. Let's look at this table quickly, and we can see that if we trade direction, where we buy a stock, for example, we buy a stock, the only way we make money is if the stock goes up, and if the stock goes down, we lose money, and our ratio of making money to losing money is one to one. If the stock goes up, $1, we make $1, the stock goes down $1, we lose $1, but when we move into options, we actually enter into these derivatives, and these derivatives are called Greeks, they measure different rates of change in the value of an option.
In other words, the value of an option is changing by different factors. We have the factor of direction, just like we do in our long stock example, and that is called delta. We have the factor of volatility when the market gets more volatile, or it gets more quiet. This is called Vega. We have the factor of time, which is that every day that passes and option moves closer to expiration, which decreases the value of that option. That's called theta. Then we have movement, or acceleration, such that if the market moves, not only does an option go up, but it actually can accelerate or decelerate in value. This acceleration or deceleration, which we simply call movement is from the Greek gamma. We're not going to count rho, just in this simple example, we're gonna focus on these four.
In these four, we have delta, vega, theta, and gamma, and all four of these factors can introduce profits into your position, and they can introduce losses into your position. Now one of the great things in options structures is you can emphasize certain factors. If we're long call, we get to emphasize direction, because we're long, movement, which is gamma, and volatility which is Vega. If we get an explosive move in a stock, an explosive move up, the call is going to explode in value, because it has three factors working for it, it has direction, it has movement, and it has volatility. You get the triple, and that causes price to explode. Now against the call, we also have direction where if the market goes down, we're going to lose money. We have time, as time passes, the chance of the call working or being in the money goes down, and lastly, we have volatility. Volatility can decline. If people think the markets going to be quiet, the market is going to decline. We have three factors that can work against us, we have delta or direction, we have time, and we have volatility. If we're able to anticipate not just direction, but the other factors, we can create amazing trades that massively outperform underlying.
We're going to talk about the five Greeks, and we're gonna go over briefly the definitions. The Greeks are measurements of risks that reflect the variables that influence the price of an option. There are five Greeks: Delta, Gamma, Theta, Vega, and Rho. We're gonna go over the general definition, and we'll get into some more specifics.
Delta is the measure of the sensitivity of an options theoretical value to change in the price of the underlying. Gamma is a measure of sensitivity of the options Delta to a change in the price of the underlying. Theta is a measure the sensitivity of an options theoretical value, to a change in the amount of time remaining until expiration. Vega is a measure of the sensitivity of an options theoretical value to a change in volatility. Rho is a measure of the sensitivity of an options theoretical value to a change in interest rates.
Let's talk about delta. We talked about the basic definition. There's actually four different definitions or four different interpretations of delta. We talked about the main one, which is the rate of change. This is how much the option value changes with respect to a change in the price of the underlying. A call with delta 25 can be expected to change its value at 25% of the rate and underlying. We're looking at a stock and we're looking at a call on a stock. If the stock rises $1 and the call has a 25 Delta, we would expect the call to go up by 25 cents. If the stock goes down by $1, then we expect the call to go down by 25 cents.
The second definition is the hedge ratio. This is the proper ratio of underlying contracts to options required to establish mutual hedge. Underlying contracts always have a Delta of 100. The proper hedge ratio can be calculated by dividing 100 by the options delta. An at the money option which has a delta of 50, we have a proper hedge ratio for an at the money option is 100 divided by 50, or two at the money options to one underlying.
The third interpretation is the theoretical or equivalent underlying position. This is the measure of directional risk of an option position with a position of similar size and underlying. If you long an options contract with the delta 50, you control approximately half of an underlying contract. If you're long 10 such contracts, you are long 500 deltas, or five underlying contracts.
The final definition is the probability that the option will finish in the money. This is the likelihood expressed as a percentage that the option will finish in the money. A delta of negative 25 for puts or positive 25 for calls can be interpreted to mean that the option is a 25% chance of finishing in the money, so it's likely to not be in the money.
When we talked about deltas, puts have negative deltas, calls out positive deltas. What this means is put deltas increase as the market breaks. They get more negative. Call deltas, increases the market rallies, they get more positive as the market rallies. In general, the sum of a put delta and a call delta is an absolute value in the same stripe as 100. If the put delta is 25, the call delta should be 75. There's some exceptions to this, but in general, that is the premise. The deltas of out of the money options decrease towards expiration, because it's less and less likely that they can be in the money.
Alright, let's talk about gamma. Gamma measures the rate of change in delta in relation to a change in the price of the underlying. Gamma is a tool that's used to manage positions. Gamma tells you how stable your delta is. A big gamma means that your delta starts to change dramatically, for even a small move in the underlying. A small gamma means that your delta is less volatile, and more stable.
Gamma characteristics: Both long calls and long puts have positive gamma. If you buy a call, or you buy a put, you're getting long gamma. Short calls, and short puts have negative gamma. If you sell a call, or you sell a put, you're getting short gamma. Long calls and long puts, you get longer deltas, the market rallies, you get shorter deltas if the market breaks. If you're long a put, and the market rallies, you get less short. If the market breaks, you get more short. If you're long a call in the market rallies, you get more long, if market breaks, you get less long. Now if you think about this for a minute, this is what we want, right? We want to get longer as the market goes up and less long or shorter as the market goes down. That's awesome. That's one of the benefits of long gamma.
When we're short a call and short a put, we get shorter deltas as the market rallies and we get longer deltas as the market breaks. It's kind of the opposite of what we want. We're getting shorter and shorter as the market goes against us, and we're getting longer and longer as the market goes against us, and that's not good. This is why one of the aspects of the pain of being short options is a gamma is working against you and you're always positioned the wrong way. When you're long gamma, you're always positioned the right way.
Okay, theta, also known as time decay, is an estimate of how much the theoretical value of an option decreases with each passing day where there's no change in the price of the underlying or the volatility. If we're short options, and the market doesn't move, but a day passes, you're going to be make money because that option is going to decrease in value. Conversely, for long options, we're going to lose money, because it's going to decay every day that that the market doesn't move, it's going to decay. Remember, when we're long options, time is our enemy, the passage of time will decay the value of your option. The passage of time can also override any changes in the price of the underlying meaning that you could be right about your direction of the market, and still lose money.
For theta characteristics, if you're long options, you pay theta, it doesn't matter whether you long a call or long a put, you pay theta on both. If you're short options, you collect theta. Since options are continually losing our time value, a long option position will lose money, because of theta, while short option will make money because of theta.
A lot people fall in love with theta because they liked the fact that every day they have their position on it decays a little bit, so kind of pays them and pays them and pays them and they like that. It's a little bit of an illusion, though, you've heard me talk about this, because you'll hear me talk about you'll make money, make money, make money, BAM! you'll lose it all. And that's what happens. You're short options, you're collecting theta, you make money, make money, make money as your theta comes out every day, but then you're short gamma. If you get a big move, all of a sudden you end up accumulating a position in the wrong direction. Say your short calls, you make money, make money, make money, and then the market takes off, and when it takes off, your negative gamma makes you really short stock, and now you're getting clobbered on the stock, and you're losing more on the move that you made into theta. That's the danger of it.
Vega. Vega measures the degree of change in an options price when there's a 1% increase in the volatility of the underlying. Vega represents the change of the price of an option for 1% change in volatility. It can also be reflected in terms of dollars. If we have an option, it's worth 10, and the vega is 50 cents and volatility goes up 1%. Without the market moving, the option will go up in value from $10 to $10.50. You can make money being long options without the market moving. This happens if volatility goes up. This is often what happens before stock earnings reports. When we're long Vega, both long calls and long puts have positive Vega. You buy a call or you buy a put you're getting long vega you're getting long volatility. If you're short calls or short puts your negative vega you're short volatility.
One things I want you to notice is that delta. The delta of calls and puts are opposite, but every other Greek is kicking out the same. If I'm long gamma, if I'm long a call or long a put, but they're both long gamma. Theta, if I'm long the call long a put, they're both paying theta. Vega if I'm long a call, long a put, they're both long volatility. The only difference between a call and a put, if you're long a car long up, and as long a put the only difference between the two is the directional component. A put is short call as long, but every other aspect of the Greeks is the same.
The final Greek is called rho when I can get into rho too much because rho is actually somewhat complicated, but is the fifth Greek and what rho does is it measures the sensitivity of an options price to a change in interest rates. Rho effects stock options differently than affects future options. This is because of how margining is done. Marching is done differently. We're going to put that to the side for today, but that's rho. Rho is a sensitivity to change in interest rates. Like this year, where rates have gone up a lot rho has had a significant impact on option positions.
Stay tuned every Tuesday for additional webinars that will teach you different ways to think about trading that will help you take your performance to an elite level. I hope you found this lesson on Greeks helpful. There's some great information here. It's probably worth watching it at least twice. Have a great week. I'll see you next week. God bless. Bye