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Once many beginning options traders have figured out the basics of puts, calls and some of the combination strategies, they stop right there with not much attention ever focused on what is known as the Greeks. The Greeks can provide the option strategist with some very important information in regards to risk and what is required to limit that risk. In this installment of Back to Basics we will define and demystify the Greeks as well as provide some practical knowledge that can be applied to your options trading approach.

First of all, what do the Greeks in the context of options trading mean? It really isn’t very complicated once they are defined and categorized by what they tell us about the risk of our options position. The Greeks in option trading that we are most interested are: delta, gamma, vega, and theta.

The Greek delta is defined as the change in the price of an option compared to the change of the underlying instrument. We apply his measurement to determine how much the price of an option will move for each point move in the underlying security. Now that you know what delta means, think of gamma as the change in the delta of an option relative to the change in price of the underlying asset. Gamma facilitates the trader in measuring the change in an option’s delta when the underlying asset actually moves.

Vega is a very important Greek to the pure volatility trader because it gauges the change in the price of an option relative to its change in volatility. Remember volatility is one of the most important factors of an option’s price and vega calibrates the amount an option will increase or decrease with a 1 percentage point change in the implied volatility of the option.   

For sideways strategy traders employing positions such as butterflies and calendar spreads the Greek theta is a key piece of information to monitor. Theta measures the rate of time decay for an option. The important characteristic to note about time decay is that it is not linear, meaning, as an option gets closer to expiration the time decay increases at a much faster rate. This is why options with one month until expiration will have a larger theta value than an option with same strike price that has nine months until expiration.

Now the challenge for the options strategist and particularly the delta neutral trader is to effectively interpret and manage these Greeks not only at trade initiation but also throughout the life of the position. The first thing to realize is that changes in the underlying instrument causes changes in the delta which then impacts all the other Greeks.

Keep these rules in mind when evaluating the Greeks of your position. The delta of out-of-the-money options are smaller and they continue to decrease as you go further out-of-the-money. When the options strategist purchases options, theta is negative and gamma is positive. In this situation the position would lose money through time decay but price movement has a positive impact.

When the trader sells option premium then theta is positive and gamma is negative. This position would make money through time decay but price movement would have a negative effect. Also, theta and gamma both increase the closer the position gets to expiration and they are larger for at-the-money-options.

In addition, when selling options, vega is negative and if implied volatility rises the position loses money and if it declines the position will make money. Conversely, when a trader purchases options, vega is positive, so a rise in implied volatility is profitable and decreases have a negative impact on the position’s profitability.

To be an effective options strategist, particularly if you want to make delta neutral type adjustments, it really is paramount you understand these Greek basics and be able to apply them to your options strategies. These very important measurement tools coupled with the position’s risk graph can provide the necessary information that will allow you to consistently execute profitable trades and send your equity curve into an upward spiral.

Happy Trading.


Jeff Neal
Staff Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
jeff@optionetics.com

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