Demystifying Options: Know Your Greeks - Part 3
...continued from Part Two
Theta: Paying for Gamma
The daily cost of owning an option is known as its "Time Decay" or Theta. In effect, it is the daily cost of insurance against uncertainty. The quicker the odds change, the greater your uncertainty and the higher will be the Gamma and the Theta of your option.
Thus, at the- money options that are close to expiration tend to have the highest Theta, while those with longer maturities tend to have lower Theta. In our service, Theta is expressed in dollars of expected one-day time decay on a 100-share option position.
Looking at Table 1, notice that the at-the-money 182-day call has a Theta of $4.19, while the five-day option has a Theta of $24.46. Option buyers should know what it costs per day to own an option, while option writers should know what their current daily rate of accrual is for assuming the risk of the option.
Vega: Exposure to Volatility
Vega is the term for an option premium’s exposure to a one percentage point change in implied volatility. (Implied volatility is the volatility number needed to generate a particular premium when all of the other variables, such as stock and strike price, are known.)
Notice that the 182-day at-the-money call has a Vega of $27.34. That means that if the implied volatility of the call were to rise from 52% to 53%, the premium on a 100-share option position would rise by $27.34 from $1,500 to $1,527.34.
Vega can work very much in your favor if you own a longer-term option and the implied volatility rises. It can work against you heavily, however, if this volatility declines. Therefore with longer-term options, it is important to know whether an option is underpriced or overpriced, since the can quickly expand or contract even if the stock doesn’t move.
Rho: Sensitivity to Interest Rates
In our service, we report Rho as the sensitivity of an option on 100 shares to a one percentage point rise in interest rates. To understand Rho, you need to know that, with an option, the underlying price is really the future delivery price of the stock.
This future delivery price is determined by the stock price, interest and dividend (if any) and the maturity of the contract. Basically, to hedge an option, the market maker must borrow the funds at the going interest rate to buy the stock. This adds to the underlying price.
In addition, to be competitive, the market maker needs to deduct future dividends. Thus, a rise in the interest rate will make the effective price of the underling higher. This will, in turn, cause call premiums to rise and put premiums to decline. Notice in Table 1, that, Rho is higher for the options with the longer maturities and also higher for calls that are in-the-money."
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