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 arguably 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.

Again, below is a very basic way to begin thinking about the concepts of Greeks that I explain in my Options for Beginners course:

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 100-delta position is equivalent to being long 100 shares.

An easy way to think about delta is that it can represent the probability that an option has of finishing in the money (a 40-delta option has a 40% chance of finishing in the money). At-the-money options tend to have a delta near 50. Think about it this way, if you buy a stock today, it has a 50% chance of going up and 50% chance of going down. In-the-money options typically have a delta greater than 50, and out-of-the-money options are typically less than 50. Increasing volatility or time to expiration, in general, causes deltas to increase.

Gamma measures 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 more your directional risk increases as the underlying moves. At-the-money options and those close to expiration have the largest gammas. Volatility has an inverse relationship with gamma, so as volatility increases the gamma of the option decreases.

Theta measures 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. Options near expiration and at-the-money have the highest theta. Additionally, theta has a positive relationship with volatility, so as implied volatility increases, theta also generally increases.

Vega measures the sensitivity of an option to volatility, represented as the change in option price per unit (percent) change in volatility. If an option has a vega of .2 and the implied volatility increases by 1%, the option value should increase by \$.20. Options with more time till expiration will have a higher vega value compared to those nearer to expiration. At-the-money options are most sensitive to changes in vega.

Rho represents the option’s sensitivity to 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
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