Before entering into any trade, it is important to understand the risks of the trade. Options market is much more riskier when compared to equity market. If you enter the options market without actually knowing how it works, you could end up losing so much money. Even though the price of an option depends mainly on the price of the underlying stock, it varies not just by the movement of the underlying stocks but there are other factors that affect the price of the option, called 'the greeks'. In order to become a better options trader it is important to learn about the option greeks.
There are two types of greeks - first order greeks and second order greeks. The first order greeks are those that directly affect the price of an option and the second order greeks are those that affect other option greeks.
The most commonly used option greeks are
1. Delta
2. Gamma
3. Theta
4. Vega
Delta
Delta helps us to determine how much the price of an option change with respect to the change in the price of its underlying asset.
For example, if we have a call option of ABC with share price of 500, and if share price of ABC moves from 500 to 501, then the call premium also increases by a certain amount. Suppose the option premium increased by Rs 0.50, then the option is said to have a positive delta of 0.50. The delta value may also be denoted as a percentage (50%) or as a whole number (50).
A call option with 0.25 delta means that for every 1 rupee change in the underlying stock price, the option premium changes by Rs 0.25. The call option is said to have a positive delta where as a put option is said to have a negative delta because with increase in the price of the underlying asset, the premium of the call option increases and premium of the put option decreases. Hence, the value of a call option delta ranges between 0 and 1, and the value of a put option delta ranges between 0 and -1. Delta value is higher towards ITM (in the money) strike prices and lower towards OTM (out of the money) strike prices.
Gamma
Gamma is the rate of change of delta of an option, in response to the change in price of the underlying asset. Delta of any strike is not a constant. It changes with respect to the changes in the price of the underlying asset. This change in the value of delta for each unit change in the price of the underlying asset gives us gamma.
For example, suppose the premium of a call option of ABC is Rs 15, delta is 0.50 and gamma is 0.003. Then, 1 rupee change increase in the price of ABC would result in an increase of Rs 0.50 in the price of the call option premium and the value of delta increases by 0.003. Like delta, the value of gamma is also not a constant. With changes in the value of the underlying asset, value of gamma also changes. Gamma is highest at ATM (at the money) strike prices and lower towards ITM (in the money) strike prices. Gamma value is also affected by the time to expiry of the option and volatility of the underlying asset.
Theta
The value of an option declines with time. Theta is a measure of the rate of change of an option's value for a one unit change in the time to the option's expiration date.
For example, Suppose the premium of a call option of ABC is Rs. 15 and at 30 days for expiry, its theta value is 0.2. It means that the option premium decreases by Rs 0.2 per day. The value value of theta of an option is not a constant and it increases as the number of days for expiration decreases. Other than expiry time, other factors that affect theta value are volatility and moneyness. Theta value will be higher when time to expiry is less, volatility is high and option strike is near ATM (at the money).
Vega
Vega is the measure of the rate of change of the option premium with respect to the change in volatility of the underlying asset. With each 1% change in volatility of the underlying asset, how much the value of the option premium changes is given by Vega.
The vega value of an option increases as the volatility increases. Also, the vega will be higher at ATM (at the money) strike price and it decreases as the strike price moves towards ITM (in the money) or OTM (out of the money). Another factor that affects vega is the time to expiry of the option. The vega value decreases as the time to expiry decreases.
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