The price of an option is a function of the risk-free interest rate, the cost of dividend, the strike price, the underlying stock price, the implied volatility, and time to expiration. The price of an option is a function of all these factors, and the option greeks tell us how much each one of them plays a role in the price.
That said, you don’t necessarily need to be an expert at the option greeks to have success trading options. However, it can be beneficial depending on which strategy you’re trading.
Option Greeks: Delta
The option greek delta tells us how much the price of an option will change for each dollar move in the underlying stock price. For example, check out this options chain on Facebook:
With the stock trading at $165.62, the options that are closest to the at-the-money price are the $165 calls. If you look to the left, these options have a delta of $0.54.
What does it mean?
It means if Facebook stock rises by $1, the value of the options will gain $0.54, all else being equal. Now, the further in-the-money an option is, the more or less it will move like the stock.
For example, the $152.5 call is more than $13 in-the-money, the delta on those call options is $0.81. For instance, if Facebook were to drop $1, those options would lose $0.81, all else being equal.
Of course, the farther out-of-the-money you go on call options, the smaller the delta becomes. For example, the $180 calls have a delta of $0.19. If Facebook were to gain $1 point, those options would gain $0.19, all else being equal.
As you can see, Delta tells us how much the price action influences the value of the option.
But how does it work for puts?
Puts have negative delta’s. For example, the $167.5 puts have a delta of -$0.52. In other words, if one put contract represents you are short 100 shares, a -0.52 delta is like being short 52 shares, the 180 puts being short 82 shares, and the 155 puts being short 24 shares.
That’s just another way to look at Delta. The highest value a call delta can reach is 1.0, and the highest amount a put delta can reach is -1.0, which happens on expiration when options expire in-the-money.
Option Greek: Theta
Option premium consists of intrinsic and extrinsic value. The intrinsic value is what the option is worth on expiration day. The extrinsic value is the probability and time factor in the option value. Furthermore, theta tells us how much an option gains (or loses) per each day time passes.
Source: think or swim
The Facebook options we’re looking at above expire in 29 days. The $165 calls have a theta of -0.11.
In other words, if you are long these calls, they will lose $0.11 of option value tomorrow. Theta is not a constant number; in fact, time decay accelerates as it approaches expiration.
Now, let’s say you decided to short the $165 calls, if you do that, you would be gaining $0.11. When you are short options, time decay works in your favor. Long calls and puts have a negative theta. While short calls and puts have a positive theta.
Option premiums lose value over the life the contract. That’s why many of the top option traders, like Jeff Bishop, sometimes prefer option selling strategies.
(This is an options strangle that paid off well for Jeff and his clients if you’d like to learn more about how he trades options, make sure to pick up a free copy of Option Profit Accelerator.)
As a rule of thumb, longer-dated options are less sensitive to time decay, while shorter-dated contracts are susceptible to time decay.
Option Greeks: Vega
If you speak to any serious options trader, they will tell you, “it’s all about the vol.” That said, Vega is the rate of change in the option for each 1% change in the implied volatility. Vega tells how sensitive our options are to shocks in implied volatility.
Looking at the same Facebook options, the $165 calls have a vega of $0.19. That means if implied volatility in those calls rose by 1% the long call options would gain $0.19. If you buy a call or a put option, you are long vega. If you are short a call or a put option, you are short vega.
For the most part, implied volatility usually spikes when there is uncertainty. We see this a lot during an earnings event. That said, the higher the implied volatility is, the more extrinsic value the options have. On the other hand, options with lower implied volatility have less extrinsic value.
Some strategies look to exploit Vega. For example, a long straddle position that seeks to profit off spikes in volatility. While strategies like the iron condor, seem to take advantage of a “vol suck.” Either or, the Vega will tell you what your exposure is to volatility.
You can find option greeks on an options chain. Many factors go into pricing an option. The option greeks help us identify how much influence those factors have.
The math with option greeks is simple.
For example, let’s say we were long ten calls of the $180 strike Facebook Options, here is what our total position would like.
- .Delta equals $0.19 x 10 = $1.90 in premium
- Theta equals -$0.07 x 10 = -$0.70 in premium
- Vega equals $0.13 x 10 = $1.30 in premium
As you can see, Vega is nearly as important as Delta is with these out-of-the-money options. It’s another reason to know the greeks. It gives us an idea of what we need for our position to make money.