Why to use Greeks in trading options?
Using Greeks in trading options can confuse a trader but can be extremely helpful.
By Guy Avtalyon
Greeks in trading options can provide helpful information, but also they can add a bit of complexity that can confuse options traders. Greeks in trading are a measure of how some option’s price is sensitive to its basic parameters, volatility, or price of the underlying asset. This measure is important when you analyze the sensitivity of your options’ portfolio or single option. So many traders and investors think this is a vital measure for decision making in options trading.
The key Greeks are Delta, Gamma, Vega, Theta but some will include Rho too. Also, you’ll find some other Greeks derived from these four or five.
Greeks in trading options can indeed hide the most important part, the difference between the stock price and strike price and the value decrease with reducing time to expiration on the option. For these reasons some options traders never examine the Greeks at all when making trades. But they are important and we will show you why.
The importance of Greeks in trading options
It isn’t easy to have an accurate prediction of what is going to happen to the price of the option especially when the market is moving. Even more difficult can be to predict the options positions that efficiently couple multiple individual positions. That is the case with options spreads, for example.
The problem is that most options trading strategies require the spreads, anything that can help you to predict the option position is important and you have to know them better. These measures can be very useful when you have to predict the future of the option price since they measure the sensitivity of a price related to the price of the underlying assets, interest rates, volatility, and time decay. By having all this information you can be in a much better position because you will know when and which trades to make.
How is that possible?
The Greeks in trading options will provide you a hint of how the price of your options will run related to how the price of the underlying asset changes. Also, the Greeks will help you forecast how much time value an option is losing daily. Moreover, by using Greeks in trading options you will have a valuable tool for risk management. In other words, you can use these measures to understand the risk for each position and where the risk will appear. Greeks will help you to recognize which risk factors you have to remove from your position and your positions’ portfolio. Also, they can show you how much hedging you need for that.
Keep in mind, you can use Greeks as an indicator of how the price will go related to different factors but they are theoretical. To make this more clear, Greeks are actually values based on mathematical rules and can be accurate only if they are calculated according to the exact mathematical model.
How to calculate Greeks?
It is possible to do yourselves but, we have to warn you, the process is complex and you’ll need a lot of time for that. Usually, traders use some software to do that for them and get accurate calculations. The serious online broker will automatically present values for the Greeks in the options they display. That makes the use of Greeks in trading options a lot easier.
Anyway, we will show you how to calculate the four most popular Greeks.
Calculate Greek Delta
Delta, the sign is Δ, can measure the sensitivity of price changes related to the moves in the price of the underlying assets. So, for example, when the price of the underlying asset grows by some amount in money, the price of the option will change by Δ amount. Here is the formula to calculate that Δ amount
Δ = ∂V/∂S
∂ represents the first derivative
V represents the option’s price which is the theoretical value
S –represents the price of the underlying asset
Why did we take the first derivative of the option and price of the underlying asset? Because the first derivative is a measure of the rate change of the variable over a determined period.
The delta is visible as a decimal figure from -1 to 1. For example, call options will have a delta from 0 to 1, but puts will have a delta from -1 to 0. We have to point one important thing here, to give you a better perception of how to understand Delta numbers. When you see the option’s delta is close to 1 or -1, you will know the options are deep-in-the-money.
Also, you can calculate delta for your options’ portfolios. It is the weighted average of all deltas of options added to the portfolio. As one of the Greeks, delta can be a hedge ratio, also. When you know the amount of delta, you can hedge your position if you buy or short the number of underlying assets multiplied by delta. It’s quite simple, don’t you think?
Gamma as one of the Greeks in trading options
Gamma or Γ is a measure of the rate of change of its delta per 1-point move in the price of the underlying stock.
The formula to calculate is expressed as:
Γ = ∂Δ/∂S = ∂2V/∂2S
The gamma can be expressed as a percentage also. And as same as delta, gamma is changing even with very small moves of the underlying asset price. Gamma is at its peak when the asset price is near to strike price of the option. It drops when the options go deeper out of or into the money. When the option has gamma value close to 0 that means it means the option is very deep out of or into the money.
Long options will have positive gamma values. When the options strike price is equal to the price of the underlying stock gamma will have the maximum value.
One of the Greeks in trading options is Vega
Vega or ν is also an option Greek. It measures the influence of changes in the underlying volatility on the option price. In other words, it measures the sensitivity of the option price in comparison to the volatility of the underlying stock. Vega will show the change in the price of the option for each change in underlying volatility, for every 1% of it.
Here is the calculation:
ν = ∂V / ∂σ
∂ represents the first derivative
V represents the option’s price which is the theoretical value
σ represents the volatility of the underlying asset
The vega is shown as a money amount.
Options will be more costly when volatility is higher. So, when volatility rises, the price of the option will rise too. Consequently, when volatility decreases, the price of the option will drop also. Hence, when you want to calculate the new option price caused by volatility changes, you have to add the vega when volatility goes up. This means, to subtract it when the volatility decreases.
Theta
Theta symbol is θ. It is a measure of the sensitivity of the option price relative to the option’s time decay. If the date of expiry is closer by one day, the option’s price will change for the theta value. The theta is related to the option’s time to maturity.
The formula is:
θ = ∂V / ∂τ
∂ represents the first derivative
V is the option’s price in sense of theoretical value
τ represents the option’s time to maturity
Generally speaking, the theta is expressed as a negative figure and it is negative for the options. Well, for some European options it can be positive. This is possible because theta describes the most negative value when the asset is at-the-money and shows the value by which the option’s price will decrease every day.
Long-term options will have theta of near 0 because they do not lose value daily. Hence, theta is higher for short-term options, particularly at-the-money options. The reason is that short-term options have more premiums and a chance to lose every day. Theta will dramatically increase when the option is near to the date of expiry and time decay is greatest during those periods.
Rho
Rho or ρ. It measures the sensitivity of the option price related to interest rates. When a benchmark interest rate rises by 1%, the option price will switch by the rho value. The rho isn’t too important as other Greeks are. Interest rates don’t have such a big influence on option prices and they are less sensitive to interest rate changes.
Nevertheless, here is the formula to calculate:
ρ = ∂V / ∂r
∂ is the first derivative
V is the option’s price meaning the theoretical value
r is the interest rate
The call options will have a positive rho, but the rho for put options will be negative.
Why using Greeks in trading options?
In real trading, the Greeks will all change and develop their changes over the other variables. Every single change in the underlying asset’s price, interest rates, the expiry date may influence all variables simultaneously. So, it’s a smarter decision to use some software to calculate the final result.
But it is very important to know why and how the Greeks can help and provide you a measure of position’s risk and reward. When the Greeks in trading options become familiar to you, apply them to your trading strategies. It is necessary to use all types of risk-exposure measures. This may bring your options trading to a higher level.
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