When trading options, comprehending the “Greeks” is essential for assessing the risk and potential reward linked to various positions. The Greeks are mathematical metrics that help traders forecast how an option’s price will alter under different market conditions. They measure an option’s sensitivity to factors such as time, volatility, and the price of the underlying asset. The primary Greeks are Delta, Gamma, Theta, Vega, and Rho.
- Delta (Δ):
In simple terms, Delta indicates how much an option’s price is expected to change with a 1-point move in the price of the underlying asset. For example, if the Nifty increases by 100 points and the Delta is 0.30, the option’s premium is expected to rise by Rs.30. Delta values range from -1 to 1, with calls having values between 0 and 1, and puts between -1 and 0. A Delta closer to 1 or -1 indicates the option is deeper in-the-money. Puts have a negative Delta because their premiums drop when the underlying price rises. Delta is also known as a hedge ratio. A trader can hedge their position by buying or shorting the underlying asset in proportion to the Delta value.
For instance, if a trader buys a 25000 strike CALL at Rs.100 when Nifty is at 25000, the option is at-the-money (ATM). When Nifty rises by 100 points to 25100, the new premium will be 100 * 0.5 (Delta) = Rs.50, so the option price increases to Rs.150.
- Gamma (Γ):
Gamma measures the rate of change in Delta as the price of the underlying asset moves. A high Gamma indicates that the Delta can change rapidly with small price movements. At-the-money options have the highest Gamma because their Deltas are most sensitive to underlying price changes. Gamma helps traders gauge Delta’s stability—higher Gamma means a greater potential for Delta to change. Gamma is also highest for options closer to expiration.
For example, if a trader buys a 25100 CALL when Nifty is at 25000, it is an out-of-the-money (OTM) call. The premium is Rs.100, and the Delta is 0.4. If Nifty rises by 100 points, the 25100 call becomes an ATM option, and the premium rises to Rs.140 (100 * 0.4). The Delta changes from 0.4 to 0.5, meaning Gamma is 0.1 (50% – 40%).
- Theta:
Theta measures the rate at which an option’s value or premium decreases over time. This time decay accelerates as the expiration date approaches because there is less time for the option to become profitable. Theta benefits sellers, as they gain from time decay, while it is a disadvantage for buyers. Theta is typically highest for at-the-money options because less time is needed for a price move in the underlying asset to produce a profit. - Vega:
Vega measures the risk of price changes due to shifts in implied volatility, or the expected future volatility of the underlying asset. Unlike Delta, which measures actual price changes, Vega focuses on the potential changes in the asset’s volatility. When volatility increases, options become more expensive due to a higher likelihood of reaching the strike price. Vega tells traders how much an option’s price is expected to increase or decrease with a 1% change in implied volatility. Option sellers gain from a drop in implied volatility, while buyers are adversely affected. Vega is most significant for options far from expiration. - Rho:
Rho measures how much an option’s price changes in response to shifts in interest rates. It is considered the least influential of all the Greeks but still has an impact, especially for options with long expiration periods. Rho indicates the sensitivity of an option or portfolio to changes in interest rates. For example, if an option has a Rho of 1.0, a 1% increase in interest rates will increase the option’s value by 1%. Rho is positive for calls, as higher interest rates typically raise their value, while it is negative for puts, as higher rates reduce their value.