Greeks: The ABCs of option trading

Greeks: The ABCs of option trading

Apr 15, 2020 | 0 comments

Just like Greek gods might have ruled the universe from atop Greece’s Mount Olympus, option Greeks rule over options trading and play a big role in your strategy. You see, armed with Greeks, you’ll be able to make more informed decisions about which options to trade and when you should trade them. 

Named after the Greek letters Delta, Gamma, Theta, Vega and Rho, option Greeks provide a way to measure and quantify the sensitivity of the price of an option or set of options and enable you to understand the risk exposures related to those.

Delta, the hedge ratio and the first of the Greeks, defines the likelihood of an option expiring in the money, measuring how much the price of an option might change per $1 fluctuation in the price of the underlying asset. 

Gamma measures the rate of change of the Delta, or how much the option’s Delta should change when the price of the underlying asset goes up or down. 

Because options lose value as they near expiration, Theta allows you to get a sense of how much of that value you can expect to lose if all other factors remain equal. 

Volatility is one of the most crucial things affecting the value of an option. Vega allows you to understand how sensitive an option could be to price swings caused by the volatility of the underlying asset and how that volatility can affect the price. When Vega drops, both calls and puts are likely to decrease in value, whereas when Vega rises, both calls and puts are likely to increase in value.  

Although not a crucial factor in determining the value of an option, Rho should be taken into consideration when interest rates are expected to change, such as around Federal Open Market Committee meetings, as it can tell you how much the price of an option should increase or decrease based on the adjustment of the interest rates. When interest rates go up, the value call options usually increase, while the value of the put decreases.  

Because the price of an option can be affected by many market conditions, using pricing models to calculate Greeks can help you measure the various factors that can affect the price of an option contract and determine the impact of each factor when the value of it changes. 

Armed with Greeks, you will be able to make more educated decisions about which options to trade and when to trade them.

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