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A Brief Intro to The Greeks - Options Mastery Series Lesson 7

Filed Under Options Mastery Series 

One of the main objectives of The Option Pricing Model is to come up with the theoretical value of an option, which allows a buyer or seller to come up with an estimated value within the context of the input variables. However, Theoretical value is not the only important output of the option pricing model. There are other important outputs produced by the model and these important outputs are called the “Greeks”.
In his Options Mastery classes at Options University, Ron Ianieri describes the Greeks in the following manner: “The Greeks tell us ahead of time, before we enter into a trade, what the potential risks are and to the exact amount that they are going to affect both our price and our position. You can’t ask for a more powerful risk management tool than the Greeks”.
There are four main Greeks that option traders need to understand. The first one is Delta. It’s called the first derivative because Delta measures the correlation of the movement of an option in relationship to the underlying stock. If an option contract has a Delta of 50, which means if the underlying stock moves $1 the corresponding option will move 50 cents. A Delta of 100 means that the option exactly mimics the movement of the underlying stock. This usually happens with deep in-the-money-options. As a matter of fact, an option near 100 Delta is really a surrogate for the underlying stock and much less an option in the classical sense.
The second important Greek is Gamma. One of the idiosyncrasies of stock is that some options are more sensitive to movements in the underlying stock than the others. Traders would like to know before entering a trade how much an option is going to move in relation to the underlying. From a statistical stand point, Delta measures rate of change of the option. Gamma is like the Delta of the Delta in that Gamma measures the rate of the change of the Delta with movements in the stock.
The next Greek is called Theta-a measure of time decay. An option price is made up of two components: intrinsic and extrinsic value. Theta is a measure of the rate of decay of the extrinsic component of the option price.
Finally, the last major Greek is called Vega, or volatility sensitivity. Volatility is an essential input into the option pricing modes and has an extremely important part to play in the price of an option. As a matter of fact, an option depends on volatility for its very existence. Traders would like to know the exact amount by which an option’s price may change with any movement in volatility. It’s Vega that identifies and quantifies that exact amount.
An option trader must understand the important roles that the Greeks can play to help measure risk. As a matter of fact, many traders actually look more at trading the movements of Delta and Gamma than the price movements. If you want to be an option trader, you need to fully understand the Greeks and what they can do to help appraise a potential trade.

For much more on the Greeks, Options University (www.optionsuniversity.com) has several online courses that go into great depth on this important subject to option traders.

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