Options are definitely more complicated than stocks. Their prices don’t just go up and down. They also fluctuate based on things like time, implied volatility and underlying stock movements. You may need a system to keep all the moving pieces straight.
Options Greeks Are Simply Mathematical Shorthand
Most people remember from high school that mathematical formulas sometimes use Greek letters like Pi and Delta. The same is true for options. Don’t let them overwhelm you or scare you. They’re simply fancy words to explain some very basic principles.
Greeks Describe the Behavior of Individual Options
The options Greeks discussed here simply describe certain key aspects of how individual options behave. Each call or put has a full suite of Greeks. Each one can help predict how it will behave under different circumstances.
Greeks explain why contracts gain or lose value. Most successful trades correctly used one or more of them — even if the investor didn’t realize it.
Because they’re a little confusing, we’ve created a memory tool to keep track of the four most important options Greeks: Delta, Gamma, Theta and Vega.
Delta: D Is for Direction
Delta is the most basic and important of all the Greek letters.
- Delta shows how much an option tracks its underlying stock or ETF.
- Delta is expressed in cents.
- Delta is positive for calls and negative for puts.
If a call has a delta of 0.50, it will increase $0.50 in value when its underlying stock or ETF rises $1. If a put has delta of -0.50, it will increase $0.50 in value should its underlying stock or ETF fall $1.
When options are sold, you simply multiply the delta by -1. Therefore, selling puts is delta-positive and the investor makes money from the underlier rising.
This is why traders sometimes speak of being “long delta” or “short delta.”
Also, because options are cheaper than the underlier, delta is the main source of their leverage.
Gamma: G Is for Gaining Delta
But delta can be tricky because it changes when a stock or ETF moves. That’s why we have gamma.
- Gamma shows how much delta an option gains or loses when the underlier fluctuates.
- Gamma shows the absolute or simple change in delta for an option based on the underlier moving $1.
- Gamma can be understood as “leverage on leverage.” Maximizing it effectively can help minimize capital at risk.
Say a call has 0.50 delta and 0.10 gamma. Say its underlying stock rises $1. The call not only increases $0.50 because of its positive delta. Along the way higher its delta rises to 0.60, resulting in a gain of more than $0.50.
When an investor correctly anticipates a stock’s direction, gamma will inflate their delta. That means their leverage may increase. Unlike holding shares, their profits won’t be a straight diagonal line up, but a steepening slope.
Vega: V Is for Volatility
Vega is how much an option changes in value when implied volatility changes on a stock or ETF.
- Vega is expressed in cents of premium per percentage points of implied volatility.
- Vega is generally higher on longer-dated options and lower on shorter-dated options.
To illustrate, say an option has 0.50 vega and the underlier’s implied volatilility increases by 1 percentage point. All else being equal, the contract will gain about $0.50 of premium.
Remember that implied volatility shows how much the market thinks a stock or ETF will move. As a result, it tends to increase before big events like earnings or a product launch — even if the stock itself drifts sideways. Implied volatility can then drop quickly after the news occurs, which is known as a “volatility crunch.” This trend is the basis of many strangle and straddle trades.
Implied volatility can also rise when a stock falls sharply. That can inflate the value of options after a selloff, and provide the basis for some “short volatility” trades, like put selling.
In all these cases, vega is the key number to watch when it comes to implied volatility. Traders wanting exposure to implied volatility may want contracts with more vega. On the flipside, traders wanting to avoid it may opt for lower-vega calls and puts.
Theta: T Is for Time Decay
Theta is how much time value an option loses each day.
- Theta is always a negative number because of time decay.
- Theta is greater (a bigger negative number) for shorter-dated contracts.
- Theta is expressed in cents.
- Theta works against long positions and favors short positions.
- Theta increases as expiration approaches.
A contract with -0.1 theta will lose $0.10 of value each day, all else being equal.
Time decay is one of the biggest challenges for a lot of traders because it can erase the value of their options — even when they correctly anticipate the direction a stock is moving. This is especially true because theta accelerates closer to expiration.
Favoring longer-dated options is a way to avoid this problem. Even though they cost more, there’s more time for a position to play out and move as expected.
Traders looking to sell options, however, will often select contracts with more theta because they can lose value more quickly. These strategies can also capitalize on time decay accelerating into expiration.
In conclusion, options Greeks may seem confusing. But understanding them is a huge benefit to traders. Hopefully this letter-based memory system. Here’s a quick review:
- Delta: D is for “direction”
- Gamma: G is for “gaining delta”
- Vega: V is for “volatility”
- Theta: T is for “time decay”
