Because options prices can be modeled mathematically with a model such as Black-Scholes, many of the risks associated with options can also be modeled and understood. This particular feature of options actually makes them arguable less risky than other asset classes, or at least allows the risks associated with options to be understood and evaluated. Individual risks have been assigned Greek letter names, and are sometimes referred to simply as the greeks.
Meet the Greeks
Delta is the change in option price per unit (point) change in the underlying price and thus represents the directional risk. Delta is interpreted as the hedge ratio, or alternatively the equivalent position in the underlying security: a 4000 delta position is equivalent to long 4000 shares.
The delta can represent the probability an option has at finishing in the money (a 40-delta option has a 40% chance of finishing in the money). At-the-money options always have a 50 delta. In-the-money options have a delta greater than 50, and out-of-the-money options less than 50. Increasing volatility or time to expiration causes deltas to tend to 50.
Gamma is the change in delta per unit (point) change in the underlying security. The gamma shows how fast the delta will move if the underlying security moves a point. This is an important value to watch, since it tells you how much greater your directional risk increases as the underlying moves. Options at the money have the largest gammas and those close to expiration also have the largest gammas. Lowering volatility raises the gamma.
Theta is the change in option price per unit (day) change in time. Also known as time decay risk, it represents how much value an option loses as time passes. Long-term options decay at a slower rate than near-term options. The theta is opposite in sign to the gamma and can represent the trade-off between time passing and the underlying security moving. Options near expiration have the highest theta. At the money options also have the greatest theta. As volatility is increased, the theta will also increase.
Vega is the risk to volatility risk, or the change in option price per unit (percent) change in volatility. If an option has a 2 vega and the vol. Goes up 1%, the option value increases by $2. Out of the money options have the largest vega as a percent of option value. Long-term options also have the highest vegas. At the money options have fairly stable vega’s with respect to changes in volatility.
Rho is the interest rate risk: the change in option price per unit change in interest rates. A position with positive Rho will be helped by an increase in interest rates and a negative rho will be helped by a decrease in interest rates.
Options Basics: Conclusion
TradingWe look at the different kinds of Greeks and how they can improve your forex trading.
TradingThese risk-exposure measurements help traders detect how sensitive a specific trade is to price, volatility and time decay.
TradingFind out how you can use the "Greeks" to guide your options trading strategy and help balance your portfolio.
TradingFind the middle ground between conservative and high-risk option strategies.
TradingSelling options can seem intimidating but with these tips, you can enter the market with confidence.
TradingLearn more about the position delta hedge ratio and how it can tell you the number of contracts needed to hedge a position in the underlying asset.
TradingIn options trading, theta measures the daily rate of decline in an option’s value as it nears its expiration date.
TradingThe Fed is expected to change interest rates soon. We explain how a change in interest rates impacts option valuations.