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Understanding The Greeks in Options Trading

By Samuel Becker · July 26, 2021 · 4 minute read

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Understanding The Greeks in Options Trading

When it comes to trading options, learning to speak “Greek”—or, understanding the relationship between “the Greeks” and options—is incredibly important. That means studying up so that terms like delta, gamma, theta, and vega make sense when you’re navigating the markets.

Options Greeks may sound like a foreign language (and it is!), but to options traders, the Greeks are incredibly important to understanding how, or if, they’re making any money, since it can be so difficult to understand the true value of an option.

A Quick Look at Options

Before we go all Greek on you, let’s do a quick refresher on options.

“Options” is short for “options contracts,” which are a type of investment that traders buy and sell much like stocks and bonds. But options are derivatives—that is, they aren’t really assets in and of themselves. Instead, their value (or lack thereof) derives from another underlying asset, typically a specific stock.

Traders buy different types of options, when they think that stock prices will go up (a call) or down (a put). They also use options to hedge or offset investment risks on other assets in their portfolio.

In a nutshell, though, traders typically buy options through an investment broker. Those options give investors the option, but not the obligation, to buy or sell a security at a later date, and at a specific price. Investors can buy an option for a price, called a premium, and then buy or sell that option.

So, while an option itself is a derivative of another investment, it can gain or lose value, too. For example, if an investor were to buy a call option on Stock A—basically, a bet that Stock A’s share price will increase—the value of that call option would go up if Stock A’s price goes up.

But the opposite would be true if an investor purchased a put option on Stock A, betting that Stock A’s price would go down. Similar to shorting a stock, the investor would effectively lose their bet (and see the value of their option fall) if Stock A’s share price increased.

Recommended: How to Trade Options: A Beginner’s Guide

What Are Option Greeks?

The Greeks, as they relate to options, are different ways to measure an option’s position.
Options traders use these letters to describe their option positions and make their best guess as to what might happen next with those positions as they relate to the underlying stocks.

In short, the Greeks look at different factors that could impact the price of an option. Calculating the Greeks isn’t an exact science. Traders use a variety of formulas, usually by a mathematical model. Because of that, these measurements are usually all theoretical.

Here’s a look at the most common Greeks used by traders.

Delta

The delta Greek measures how much an option’s price will change if the underlying stock’s price changes. Specifically, it measures the option’s price change in relation to every $1 change in the underlying stock. It’s usually expressed as a decimal, like “0.50,” for example.

So, if an option has a delta of 0.50, in theory, that means that the option’s price will move $0.50 for every $1 move in the stock’s price. Another way to think of delta is that it gives an investor an idea as to the probability that they’ll make money from an option. If delta is 0.50, for example, that can equate to a 50% chance or so that an option will expire in the money—that an investor’s bet will have paid off.

Gamma


The second Greek, gamma, tracks the sensitivity of an option’s delta. If delta measures how an option’s price changes in relation to a stock’s price, then gamma measures how delta itself changes in relation to a change in the stock’s price.

Think of an option as a car going down the highway. The car’s speed would be its delta. The car’s acceleration would be its gamma, as acceleration is measuring the change in speed. Gamma is also typically expressed as a decimal. If we go back to our earlier example—that delta is 0.50—and delta changes to 0.6, then gamma would be 0.1.

Theta


Theta measures an option’s sensitivity to time. It gives investors a sense of how much an option’s price decreases the closer it gets to expiration.

Similar to the “car on a highway” analogy, it may be useful to think of an option as an ice cube sitting on a countertop. The ice cube melts away—or, the option’s time value diminishes—and the melting becomes more rapid over time.

Theta is typically expressed as a negative dollar amount, and represents how much value an option loses each day as it approaches expiration.

Vega

Finally, vega is a measure of an option’s sensitivity to implied volatility.

Markets are volatile, and securities (and their derivatives) are subject to that volatility. Vega attempts to measure how much an option’s price will change as it relates to the underlying security’s volatility.

Volatility refers to the turbulence a security’s value experiences. We don’t know what level of volatility a security or option will experience in the future, however, so there’s a certain amount baked into the mix—that’s implied volatility. It’s the expected future level of volatility.

Changes in stock volatility can change an option’s value. That’s what vega is measuring—not volatility itself, but the option’s sensitivity to volatility changes.

And like delta and gamma, vega is expressed as a number, rather than a dollar figure.

Other Options Terminology to Know

The specific options (a call versus a put, for example) and the underlying stock’s performance determines whether an investor comes out ahead on their bet. That brings us to a few other key options terms that are important to know:

In the Money

A call option is “in the money” when the strike price is below the market price. A put option is “in the money” when the strike price is above the market price.

Out of the Money

A call option is “out of the money” when the strike price is above the market price. A put option is “out of the money” when the strike price is below the market price.

At the Money

The option’s strike price is the same as the stock’s price.

Recommended: Options Trading Terms You Need to Know

The Takeaway

There’s no getting around it: Options, and the Greeks, can get complicated, and may not be the best investment strategy for beginners. But experienced traders, or those willing to spend time to learn how to understand options, find them a valuable tool in creating an investment strategy.

If you feel more comfortable keeping things simple, however, the SoFi Invest® brokerage platform can be a great place to start. SoFi Invest lets you build your own portfolios with stocks, and ETFs, or to use an automated service that builds it for you.

Photo credit: iStock/photolas


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