Know Your Greek Letters for Better Trading Results

If you trade options, sooner or later you will come across terms called “option Greeks.”

They are: delta, gamma, theta, vega, and rho. Each letter describes a certain characteristic of the option.

For beginner option traders, all these different letters can be confusing. Today, let’s go through the first two, to assist your trading. We will discuss the others in a future article.

What Is Delta?

Among the five letters, the best known and most important is delta.

An option’s delta shows the sensitivity of the option price to movements in the underlying stock. Put another way, it measures how much an option’s price moves in response to movement in the underlying stock (holding everything else constant).

Call options have a positive delta (between 0 and 1) and put options have a negative delta (between -1 and 0). This is because calls move in the same direction as the underlying stock and puts move in the opposite direction.

Note that when talking about whether an option’s delta is high or low, what matters is the absolute value of the number. Thus, a put option with a delta of -0.4 has a higher delta than a call option with a delta of 0.2.

If a call option has a delta of 0.6, this means that for every $1 increase in the underlying stock, the option price is expected to increase $0.60. And for every $1 decrease in the stock, the option price is expected to fall by $0.60.

In the Money and Out of the Money

Generally, the deeper in the money a call is, the closer its delta is to 1, especially as expiration approaches. When a call option’s delta is very close to 1, then its change in terms of dollars is very close to that of the stock.

In percentage terms, though, the magnitude of change won’t be the same. For instance, if a $50 dollar stock moves up by $1, it’s a 2% gain. But if a $3 call moves up by $1, it’s a 33% gain.

The more out of the money it is, the closer the delta is to 0. This makes sense because if a call option is $20 out of the money with three days to expiration, a $5 rally doesn’t really improve the chances of it moving into the money very much. It will still likely expire worthless so buyers aren’t going to pay you much more for it.

For a put, the same reasoning from the preceding paragraph applies. The key difference is that delta will approach -1 instead of 1.

Probability of Being in the Money

Another way to think of delta is as an estimate of the probability of the option as expiring in the money. For example, 0.6 (for a call) and -0.6 (for a put) would imply a 60% probability of ending in the money.

You may wonder why doesn’t everyone buy a high-delta option then? Well, if you know that a high delta is good for the option buyer, so does the option seller. Hence, the option seller will demand a higher price for a high-delta option, all else equal. You will have to figure out whether the price is worth it.

Measuring the Change in Delta

Next up is gamma, which is related to delta. In fact, gamma is a measure of delta.

Gamma measures the rate of change in an option’s delta. This is because delta is not a static number. An option’s delta reading is its delta at that moment. The delta constantly changes over time. Think of delta as the speed of change, and gamma as the acceleration.

All long positions, whether it’s a call or a put, will have a positive gamma. All short positions (again, whether a call or a put) will have a negative gamma.

Gamma is expressed as the change in delta per $1 change in the underlying stock. So if a call option has a delta of 0.4, and its gamma is 0.02, and the underlying stock moves up by $1, then the delta would change by 0.02 (1 x 0.02) and become 0.42. In other words, as the stock rose in price, the call option became more sensitive to the stock’s move. Gamma provides information about how stable delta is.

An option’s gamma is always the largest when an option is at the money. This is because at that point, an option can quickly switch between being out of the money and in the money, and the delta has its fastest movements at that point. When an option is either deep out of the money or deep in the money, the gamma is at its lowest because in these situations, the delta won’t change very much.

Experienced traders can use delta and gamma to help them plan strategy and manage risk. Things can get complex, and it’s beyond the scope of this reading. However, even understanding what delta and gamma mean can help you in your options trading endeavors.

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As chief investment strategist of the premium trading service Velocity Trader, Jim Fink has devised an options methodology that makes money in up or down markets, in good times or bad.

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