Demystifying Options: Know Your Greeks
Meet the "Greeks"
Delta, Gamma, Theta, Vega and Rho - you are likely to hear these "Greek" risk measures whenever traders talk about options. Although these terms sound complicated, they actually are easy to understand once you grasp a few basic concepts.
Mastering them will give you a good understanding of why options behave the way they do under different circumstances.
Delta - Based on the Odds
Delta or Change per Point is the option’s sensitivity to a small change in the stock. For instance, if the stock moves by $0.10 and the option changes by $0.05, then the option is said to have a Delta of 50, meaning that it in dollar terms it matches 50% of a the move in the stock.
Conceptually, Delta is related to the probability that an option will end up in-the-money. In the top two parts of Table 1, we show premiums and the Deltas at various stock prices of a call with a $100 strike price and with different lengths of time to go before expiration: 182 days, 91 days and just five days to go before expiration.
Looking at Table 1, notice that with only five days to go, if the stock price is $80, the Delta of the $100 strike call is 0. This is because there is virtually zero likelihood that the call will end up above $100 - i.e. in-the-money.
If the stock price is $120, then the Delta is equal to 100, since there will be a virtual 100% likelihood that the option will stay in-the-money (i.e. end up above $100).
Finally, if the stock price equals $100 shortly before expiration, then the Delta will be close to 50. This is because there is 50% change that the stock will end up in-the-money and a 50% chance that it will end up out-of-the-money.
Now look at the call with 182 days to go. Notice that with the stock at $100, the odds are still reasonably close to 50/50. However, if the stock is equal to $80, the odds will be greater than zero - in this case 35% - that the stock could end up above $100. Alternatively, if the stock is at $120, the 80 Delta is generated by the 80% probability that the stock will end up above $100.
You can easily translate Delta into dollars. Here is an example: if you are long a call on 100 shares of stock priced at $100 (total underlying stock value $10,000) and the Delta is 50, then your equivalent position is $5,000 worth of the stock (or 50 shares).
Continued In Part Two...
Posted By: Value Line
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About Lawrence D. Cavanagh
Lawrence D. Cavanagh is Editor (and Senior Analyst) of The Value Line Daily Options Survey. The Value Line Daily Options Survey offers evaluations and rankings on virtually the entire universe of regularly listed equity and ETF options, using the Value Line common stock ranks and proprietary volatility forecasting methodology. Before joining Value Line in 1991, Mr. Cavanagh was an options strategist for Capital Market Technologies (subsidiary of Elders Finance), helping design long-term synthetic foreign currency and gold option hedges. Before that, he was Director of Foreign Currency Options for the Chicago Board Options Exchange. Other work experience includes Dean Witter Reynolds (VP, Senior Currency Analyst), European American Bank (Director of Currency Forecasting) and the Federal Reserve Bank of New York (Assistant Economist).
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