If you are an options trader, you may better know that prediction regarding the price of options in a continuously changing market is somehow a tough row to hoe.
Many of us must have heard the term “Options Greeks” like Delta, Gamma, Theta, Vega, and Rho.
There may be some of us, who may not know exactly, what these terms are and the myths or misconceptions associated with them.
To help those, let’s go into the details and discuss the myths and realities of Options Greeks, which will help you in busting the myths before they cause you any trouble.
So, What Options Greeks Really Are?
- Option’s Delta refers to the expected amount of movement of an option price on the basis of 1 dollar move up in the underlying stock. Delta is positive between 0 and 1 for calls and the same is negative between 0 and -1 for puts.
- Option’s Gamma refers to the rate of change in the delta with respect to 1 dollar change in the price of the underlying stock. In simple words, it shows us by how much the delta of an option will increase by, when the price of the underlying stock moves by 1 dollar. It serves as a second derivative of the option price.
- Option’s Theta is simply a measure of the time decay on the value of an option. It measures the rate with which price of calls and puts decrease with the passage of time, as the expiration date of the option approaches.
- Option’s Vega is a measurement of the rate of change in the value of an option with respect to changes in the underlying volatility. It doesn’t affect intrinsic value of an option but only affects the time value of the price of the option.
- Option’s Rho is the measurement of the expected change in the price of an option per 1% change in interest rates.
What Are The Myths Associated With The Options Greeks That Must Be Busted?
Though, options traders always turn to Greeks for guidance and these terms can be helpful, yet, some false assumptions can trip options traders up early on in their trading career.
The first misconception is that Delta, gamma, theta, and vega are what make up options’ prices.
The reality is that Greeks do not make up options’ prices but they describe what possibly can happen to options’ prices.
As cumulative buying and selling activity of market determine prices of options, on the basis of expectations of options traders regarding how much a stock price can change before its expiration.
However, these Greeks can help us in estimating how prices of options may change with changes in either:
Price of the underlying stock (delta, gamma)
Volatility (vega) or
Interest rates (rho)
The second myth is that Greeks never change and they are timeless.
The Greeks change over time as stock price, volatility, and time move at once, resultantly, those Greeks you see now may not be the ones you see later.
Any change in stock price, volatility, and time can change the Greeks as well, that can cause a change in positive and negative Vega of the strategy.
The third myth is that delta neutral is the ultimate goal of options trading.
But the reality is that delta neutral is not something very important for regular traders, as, for them, it is a simple way, describing a position designed for making money when the stock or index doesn’t move much.
Options Greeks help traders in parsing the information, the financial market is giving them and they act as a way of measuring the sensitivity of an option’s price to market movements
— The Option Specialist