An Introduction to Option Greeks & Option PricingUnderstanding Option Greeks is perhaps the most important step in learning to make money from Options. There are four Options Greeks - Delta, Theta, Vega and Rho. Each of the Option Greeks indicates the effect of a particular variable on the price of an option. Option Greeks are not very hard to understand if one understands the factors which influence the Options pricing.
The price of an Option, also known as Options premium depends on the following four factors.
- The price of the underlying.
- The number of days left to the expiry - the more the time left to expiry, the more is the risk for the seller of the option and hence more the price of the option.
- Volatility of the underlying - Volatility is a measure of how much the underlying moves in a unit time. The options on volatile stocks or index is more than options on a less volatile stock.
- The risk free interest rate - Interest rates are usually constant for short and medium term options and may only become a significant factor for long term options, also called as option leaps.
A natural question to ask.These four factors, especially the first three typically change during the lifetime of the option. When they change, they have an effect on the Options price. It is now natural to ask the following
Question - How much effect do they have on the Options price? For example, if the price of the underlying stock increases by one (one dollar or one rupee or whatever currency), and all other factors remain the same, then how much will the options price of the Option change?
Answer - This is exactly measured by Option Greek Delta. Similarly effect of other three factors is measured by the remaining option Greeks - Theta, Vega and Rho.
More Explanation of Individual Option Greeks
- Option Greek Delta : Option Greek Delta is the amount by which the price of an Option changes if the price of the underlying (stock or index, etc.) changes by one. Further Reading: There are strategies based on the concept of Option Greeks Delta. Read more about Delta Neutral Options Trading Strategy.
- Option Greek Theta : Option Greek Theta is the amount by which the price of an option changes when the time remaining for the expiry date of the option falls by one day. As the time remaining for the expiry date of the option reduces, the price of the option falls. Thus Option Greek Theta is always negative. Further reading: Options Greek Theta and its role in Options Trading Strategies.
- Option Greek Vega : Implied Volatility of an underlying stock is one of the most influential factors in determining the price of an Option. Option Greek Vega measures the amount by which the price of the Option changes when the implied volatility of the underlying changes by one. Further Reading: Options Greek Vega and implied volatility for beginners.
- Option Greek Rho : As I said before, this is one Option Greek which most of us can ignore most of the time. The reason being for Options with expiry date a couple of months away, interest rates are usually constant. Further reading: Option Greek Rho: does it really matter?
How to Calculate Option Greeks?The concept of Option Greeks itself is not hard to understand as explained above. In the individual posts you will also find easy examples. However, the formula to calculate the value of Option Greeks is quite complicated. So how to calculate Option Greeks? Fortunately I have uploaded an easy to use Options Greek Calculator in excel format. Click on Option Greeks Calculator to download it free.
Stock Market Derivatives: Futures, Options
Options Trading Basics
In the Money Stock Options
At the Money Stock Options
Out of the Money Stock Options