Delta, Gama, Theta, and Vega sounds like sci-fi terms but they are important terminologies used by traders in option trading. In options trading, change in option premiums are majorly determined by the spot price, volatility and Moneyness of the underlying. However, apart from demand & supply, there are many other factors that influence the price of an option premium.
Do you know what the factors are behind changes in option premium prices with respect to a change in the price of underlying spot price? Option premium price is determined by various factors, and you need to understand the mechanism by which the option price changes in receptive to changes in the price of the underlying.
Delta, Gamma, Theta, Vega and Rho are collectively known as Greeks. They are used to measure changes in the option price. These are the quantifiable factors that you should know if you are an option trader.
Today in this article we are going to talk about these Greeks, how they work and how these factors options with a few set of examples where required.
What is Delta in Option?
Delta measures the rate of change or you can say how much option price (premium)is changed with respect to 1 unit price change in the underlying security. To understand better, let's take an example, a delta of 0.50 value suggests if the current price of the underlying security changes by 1 point, the option premium price of the same underlying security will change by 0.50 per unit price.
Suppose the market price of an underlying security's option premium is currently trading at Rs 10, then on each 1-point change in the stock price will affect the option price by 0.50.
The positive change will affect the call option, in the put option when the delta is -0.50, the option price will go down by 0.50 on every 1-point change in price. The higher the delta for a call option, the more the price changes.
How Delta Works in Options?
Delta works differently for the call & put, as per the movement in the option price. The value of delta remains between the range of -1 to +1. So what does it means when we say delta of a security is +0.6 and how does it work in the options market? If the delta of an underlying is 0.6, it means that on every 1-point change in underlying, the option premium will change by 0.60 points.
The positive (+) delta works for a call option, but for the put option the delta value shows in negative (-). For example, if the delta is -0.6, it suggests the option premium will decrease by 0.6 units on every 1 unit change in the price of the underlying.
How Does Delta Affect Option Price?
As we got to know call option has a positive delta, while for the put option the delta is negative. But the effect of delta depends on the option strike price and how it is far away from the spot price. When you see, mostly for at-the-money options the delta remains at 0.50 levels.
Conversely, for the deep ITM options, the delta remains around 0.80 or at higher levels. The delta for OTM options remains near 0.20 levels. ITM or OTM options, the price of premium changes at a slower rate, as the delta is lower in such options. The farther the strike price of the option from the spot price, the lesser the value of the delta, which means it will be less affected by every unit of price change.
However, when the strike price of the option becomes very deep-in-the-money or you can say the delta is around 1. The option will trade like the spot price of the underlying security moving almost unit-by-unit change with the change in the underlying security.
While on the other hand, far out-of-the-money options will not have that much movement in absolute terms. The rate of change in option price is due to delta but what about the intensity, to understand let's move to another member of Greeks called Gamma.
What is Gamma in Options?
Delta tells the rate of change, while gamma measures the intensity or you can say speed of change of delta, which means how quickly delta changes itself with the change in the price of the underlying security. The higher the gamma means the delta is more sensitive, making the option price more volatile. While a lower gamma shows the delta changes slowly making the option price less volatile.
How Gamma Works in Options?
Gamma quantifies the speed of change in the delta for each one-unit price change in the underlying security. Unlike delta, gamma always remains positive for both call and put options. But the gamma will be higher for at-the-money options and that gradually comes down for both in-the-money options and out-of-the-money options.
For ex., suppose an option has a delta of 0.4, and if the price of an underlying moves by 1 unit or Rs 1, then the option price of the same underlying will move by 0.40. However, a sharp movement in the option price makes the strike price closer to the spot price, and now the delta becomes 0.55. Which means the delta becomes 0.55 from 0.40 in which 0.15 is the Gamma in the option price.
The Delta never remains constant and cannot be more than 1.00, but the Gamma decreases as the option gets further in the money and the delta reaches 1.00. High Gamma means the option price is highly volatile, while lower gamma means the change in delta will be slower due to less volatility.
How Does Gamma Affect Option Price?
The gamma shows at what rate of change, the value of delta changes with respect to changes in the price of the underlying security. The gamma is smaller when the option is in deep or OTM; gamma is at its highest when the option is near or ATM.
However, the gamma is also at the highest levels near the expiry of the option contract, compared to the option having a long day’s expiry period. When gamma decreases and reaches to zero, the option becomes a deep in-the-money and the delta reaches to 1.
While, gamma also becomes 0 with the deeper an option gets out-of-the-money and gamma reaches at its highest levels when the price of the option is at the money. Hence, when the Gamma increases the cost of buying the option over time (Theta) decreases. The option premium loses the time value with the time reaching to expiry date.
What is Theta in Options?
Theta measures the time decay of the option, which means how much the price of the option premium decreases each day when the option approaches the expiration date. This natural erosion of option price is better known as time decay in option trading.
Also Read: Best Technical Indicators for Option Trading in TradingView
Theta tells you how much the price of an option should decrease each day as the option come up to expiration if all other factors remain the same. This kind of price erosion of option price over time is known as time decay that good for the option writers and bad for the option buyers.
However, for the at-the-money options, theta increases with the option reaching to the expiration date, while for in-the and out-of-the-money options theta decreases with the expiration date getting closer for the option contract.
How Theta Works and Affect Options?
While considering all other factors remain the same, Theta measures the rate of decreasing of option price value with time passing every day. The rate of decaying accelerates in the option price as soon as the option comes near to the expiration date.
For option buyers theta works against them, as each day passing reduces the amount of time for the option to give them profit. Suppose you have a call option with the theta of -0.07, then the extrinsic value of your call option will reduce by 7%, considering all other things remain the same.
For option sellers theta works like a friend, the value of the premium you have received while writing the option contract gradually declines as time passes. This is because with each day passes, hypothetically there is less time remains for the underlying security to move in that direction where option premium becomes profitable for the option buyer.
Also Read: Why Option Selling is Better than Option Buying: Explained
Nevertheless, for the out-of-the-money options, theta is lower than for at-the-money options. And this is because the value of the premium is smaller. Hence, the loss could be also higher in terms of percentage, for out-of-the-money options that is because of the smaller time value. The option premium is also affected due to volatility in the price of the underlying. Meaning how much option premium is affected due to the volatility in underlying can be understood by analysing Vega.
What is Vega in Option Trading?
Vega measures the sensitivity to changes in the implied volatility (IV) of the underlying. The higher the value of Vega represent, option price is more sensitive to the change in volatility. While lower Vega means, the option price is less sensitive towards the change in volatility.
How Vega Works and Affects Options?
The intrinsic value of the option is not affected by the Vega, only the time value of an option is affected by the Vega. Vega measures the volatility, and when IV rises, the value of the option price also rises, as higher vol. means there is more potential for higher movement in the price of the underlying. Whereas, a fall in volatility causes all the options to decrease in value.
Also Read: How to Trade in High Volatile Market: Best Trading Strategies
The change in the IV affects both calls and puts in the same manner, but the affect on call is greater than put option. However, for ITM and OTM money options, the effect of change in volatility on option premium is much higher. The Vega decreases as the expiration date becomes nearer, hence the price of the underlying security inching towards the strike price.
Also Read: How to Choose or Pick the Right Strike Price in Option Trading
Let's take an example to make you understand this concept. Assume a trader bought a call option with the Vega value of 0.05, meaning that every 1% change in the IV will lead to increase in the option price by Rs 0.05, while keeping others things constant.
Conversely, when the volatility decreases by 1%, then the option price is likely to move by Rs 0.05 at the lower side. If the market price of the premium of an option is Rs 2 and the volatility of the same underlying security is 20%. Then every 1% increase in volatility will result in the change in the option premium by Rs 2.05, as the new volatility becomes 21% and Vega is 0.05.
Summing-up
These are some of the most important factors that will let you know how the option premium price gets changed with the change in the price of the underlying security, time decay and volatility levels. The delta will tell you how much the option is sensitive towards the movement in the spot price, while gamma measures the speed of change in the delta, or how fast it is changing.
Also Read: Best Technical Indicators for Option Trading in TradingView
Theta value tells you the rate of change in option price with the decay in time of the option contract. Finally, Vega will let you know how the option premium is affected by the change in the implied volatility of the underlying security.
Apart from these Greeks, there are various other factors too that measure and affect the price of the option price but these are essential to determine the various risks exposures in options. So that you can the various factors and pick the best stock for option trading.
Also Read: How to Select Best Stock for Option Trading: Points to Consider
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