For option traders, the Greeks are a series of handy variables that help explain the various factors driving movement in option prices. Although the Greeks collectively indicate how the marketplace expects an option’s price to change, the Greek values are theoretical in nature. There is no guarantee that these forecasts will be correct. The most common Greeks are delta, theta, and vega.
Option Trading with Delta
Delta measures the amount an option will move based on a dollar change in the underlying stock.
Typically, the delta for an at-the-money option will be about .50, reflecting a roughly 50 percent chance the option will finish in-the-money. In-the-money options have a delta higher than .50. The further in-the-money an option is, the higher the delta will be.
Out-of-the-money options have a delta below .50. The further out-of-the-money an option is, the lower its delta will be. Since call options represent the ability to buy the stock, the delta of calls will be a positive number (.50). Put options, on the other hand, have deltas with negative numbers (-.50). This is because they reflect the right to sell stock.
Option Trading with Theta
Theta is the measure of time decay — the amount an option’s price will adjust for a one-day change in the time to expiration. For example, if the theta for an option contract is $.07, in theory the time value of an option should decrease by 7 cents for each day that passes. Theta is enemy number one for the option buyer, since it measures how quickly the owner’s option is eroding in value with each passing day. On the flipside, theta is usually the option seller’s best friend, because when you sell an option, you want it to decrease in value as quickly as possible.
Option Trading with Vega
Vega is a slightly trickier concept. It’s the amount an option’s price will change in theory for a corresponding one-point change in the implied volatility (IV) of the option contract. As implied volatility increases, it indicates a potential for wider movement in the stock price. Therefore, option prices will increase as IV increases, and option prices will decrease as IV decreases.
If the vega for an option contract is .10, this means that, if the IV of the option moves one percentage point up or down, the value of the option will move accordingly by 10 cents.
Keep in mind: vega doesn’t have any effect on the intrinsic value of options; it only affects the “time value” of the option’s price. Here’s an odd fact for you: Vega is not actually a Greek letter. But since it starts with a ‘V’ and measures changes in volatility, this made-up name stuck.