Knowing and understanding the option greeks is pivotal for your potential or continued success as an option trader. Listed below are some of the finer points of delta, gamma, theta and vega. Realistically, each could have its own book explaining how it works and its ramifications, but in this options greeks quick reference guide we will present an overview to get you acquainted. Let’s start with probably the most famous of all the option greeks and that is delta.
There are several definitions of option delta, but the one I like best is that it measures how much the option price should change based on a $1 move. For every dollar the underlying moves higher or lower, the premium should change by that amount. Long calls and short puts have positive deltas. This means the position can profit if the stock moves higher based on delta. Keeping it simple, a long call (positive delta) can profit if the stock moves higher because the right to buy the stock becomes more valuable. A short put (also positive delta) becomes less valuable with a move higher allowing the trader to potentially buy back the put for less. Short calls and long puts have negative deltas. The position can profit if the stock moves lower based on delta.
Option Delta Example
Take a look at the screenshot below and notice the position is a short call with a negative delta of approximately 0.51.
If the underlying moved $1 higher, the premium would increase about $0.51 ($51 in real terms). The option trader sold the call, so he would have to spend $51 more if he wanted to buy back or close the position. A $1 move lower would have decreased the premium by $0.51 (again $51 in real terms), which would be beneficial for the short position.
Gamma can be daunting for option traders, but it doesn’t need to be. Option gamma measures how much delta should change based on a $1 move. Keeping it simple once again, gamma changes the delta based on a dollar move higher or lower. Negative or positive gamma confuses many option traders, but it is fairly simple to understand. Long options (both calls and puts) have positive gamma, and short options have negative gamma. Positive gamma increases the delta when the stock moves in the intended direction and lowers the delta when the stock moves against you. Negative gamma increases the delta when the stock moves against the position and decreases the delta when the stock moves in the intended direction.
Option Gamma Example
Take a look at the screenshot below and notice the position is a long put with a positive gamma of approximately 0.05.
If the underlying moved $1 lower, gamma would increase the negative delta (because it is a long put) by about 0.05 to approximately negative 0.70 (0.65 + 0.05). The more the underlying continues to fall, the greater the potential gains. A $1 move higher would do the opposite to the negative delta. It would decrease the negative delta to approximately 0.60 (0.65 – 0.05).
Theta is usually one of the easier greeks for option traders to understand. Option theta measures how much the option price will decline due to the passage of time. For every day that passes, the option price should decrease by the theta amount. Long options, both calls and puts, have negative theta. Short options, both calls and puts, have positive theta. The thing to remember is that options are always losing value due to time. If an option has positive theta, the passing of time benefits the position. If the position has negative theta, time passing hurts the position.
Option Theta Example
Take a look at the screenshot below and notice the position is a long call with a negative theta of approximately 0.16.
When one day passes, the premium would decrease about $0.16 ($16 in real terms) to about 11.84 (12 – 0.16). The option trader owns the call, so he would lose about $16 if he wanted to sell the call option and close the position. If a call or put had been sold, time passing would have still lowered the premium; but this would have been beneficial for a short position because of the reduced premium (cheaper to buy back).
Vega can be a bit daunting like gamma for option traders, but it does not need to be. Option vega measures how much the option price will change due to changes in implied volatility (IV). For every 1% change in IV, the option price should change by the amount of vega. Like gamma, long options, both calls and puts, are said to have positive vega. An increase in IV will benefit the position and vice versa. Short options, both calls and puts, are said to have negative vega. A decrease in IV will benefit the position and vice versa.
Option Vega Example
Take a look at the screenshot below and notice the position is a short put with a negative vega of approximately 0.04.
If IV moved 1% lower, vega would decrease the premium (because it is a short put) by about $0.04 ($4 in real terms) to approximately 3.66 (3.70 + 0.04). A 1% move higher in IV would do the opposite to the option premium. It would increase the premium to approximately 3.74 (3.70 – 0.04).
Wrapping This Up
I hope this brief explanation of the option greeks will serve as a general overview that helps you throughout your option trading career, especially at the beginning. Understanding the greeks is essential to becoming a better and more knowledgeable option trader.
Senior Options Instructor
Market Taker Mentoring, Inc.