Option Greeks explained
If you’re somewhat new to Options, you must have heard about the Option Greeks. In fact, a common rookie mistake with Options traders is that they ignore the Greeks. In this post, hopefully, I can convey the importance of Option Greeks explained in simple terms. This is easily one of the biggest mistakes a newbie Options trader can do.
You’ll find the Option Greeks explained in many complicated ways – you’ll find common explanations for Delta as the amount an Option price will change for a $1 move in the underlying, and you’ll find similar explanations for the other 3 main Greeks as well – Gamma, Theta and Vega. Let me try a slightly different explanation here.
You are an airline pilot
Put yourself in the shoes of an airline pilot. A pilot needs two sets of tools to fly the plane safely from Point A to Point B.
1) The pilot needs a map to know where to go.
2) The pilot also needs a set of reliable instruments to get from A to B.
In the Options world, the map is the Profit & Loss diagrams, and various Options simulation tools you have including the simulation of risk graphs. You look at the risk graph and you get a visual idea of where you need to go. You tweak the simulation parameters to know how your position will perform under different market conditions like Price movement, changes in Volatility or with the passage of time. You can tweak one or all of these parameters and you can see how these simulations impacts your Risk Graph. This is the Map. It’s visual. And you get a clear visual idea of how to navigate your trade by mentally setting various adjustments, and even the nature of adjustments.
The second tool is a reliable set of instruments that can get the plane from A to B. In the Options world, this set of instruments are your Option Greeks. Think of the four main Greeks as the set of four key instruments available to you as the pilot of your Options trade. If one of these instruments has overshot some pre-determined limits, you have to turn its knob to one side to bring it back into the acceptable limits. You do this for all four Greeks in an effective manner, and you’re actually guiding your plane safely to your destination. This analogy is very true – You can control every aspect of your Option position simply by tweaking the four Greeks. You don’t even need to look at what the markets or your stock is doing. You can manage your adjustment points, and once you become an expert, you can navigate your Options plane on auto-pilot. Hopefully, you have a better appreciation for how important Option Greeks are.
But what exactly are the Option Greeks ? What do they measure ? And why is it the case that these obscure terms can have such control on what’s going on in the markets ?
The key lies in the fundamental facts about what Options are, and how the Black Scholes Options pricing model was invented. You’ve probably heard before that Options are a mathematical concept. Buyers and sellers barter rights and obligations. There is no underlying security that is actually traded, you only trade contracts with rights and obligations that are “based on an underlying security” like shares of a stock. All Options also have an expiry date of some time in the future. Options do cost money, so there is a cost of “carry” of these rights and obligations. The opportunity cost of this capital is dependent on the prevailing interest rate environment. And because Options have an expiry date, they must lose some value as time passes. And once again, because of this expiry date, you have to ask this question – Within a certain amount of time, what is the probability of a certain stock reaching a certain price (strike price of the option). To answer this question on probability, you need to know the “Volatility” of the stock, with Volatility being defined in standard deviation terms based on that stock’s historical stock prices (say past 12 months).
So pricing an Option has to consider all these elements. The inventors of the Black-Scholes formula had to consider all these elements. (Notice I used the word “formula” in this sentence). And this is the key. Everything in Options pricing is a formula. The way an Option responds to price movement of the underlying stock is a formula. The way it responds to passage of time is a formula. The way it responds to changes in Volatility is also a formula and so on and so forth with interest rates, cost of capital etc. So everything is a formula. Options are a truly mathematical concept, and the price of an Option has many components to it, and each of its components responds to one or more of these parameters.
In the case of response to changes in the underlying price of the stock – the Greeks are Delta and Gamma
Sensitivity to the passage of time is measured by the Greek Theta.
Sensitivity to changes in Implied Volatility is measured by Vega.
Interest rates is Rho..and so on.
And each one of these Greeks are calculated by a formula from the Black Scholes model. Because of this fact, we can manage the entire options position simply by managing the Greeks. Imagine yourself looking down upon an instrument panel with these four main instruments. And in front of you is the market, but you’re not looking at the market because you’re looking down at your instrument panel which is getting a real-time feed of what’s going on in the markets, by way of changing Option prices. The Greeks are changing because of the change in Option prices, and all you’re doing is managing your Greeks, and navigating your trade to success. You can be oblivious of everything else. That’s how powerful Option Greeks are.