Understanding ‘The Greeks' in Options

Greeks are key risk measures and an appropriate guide for any option strategies initiated. For an option trader, understanding Greeks is as important as understanding different strategies. Greeks basically are measures which indicate the likely payoff of an option strategy with respect to change in the options key parameters viz price of the asset, implied volatility, time decay, interest rates etc. The main types of Greeks used are Delta, Vega, Theta, Rho, Gamma and Volga. While Delta, Vega, Rho, Theta are first derivatives, Gamma is the second derivatives. Let us discuss each of these.

Delta: Delta is the most popular Greek used. It is defined as the sensitivity in the option price with respect to any movement in the underlying asset. A call option has a +ve Delta while a Put option has a –ve Delta. An OTM (out of the money) option has lower Delta while it increases and the option becomes ITM (in the money). This is because, an OTM option has the highest Time Value while the deep ITM option has the highest intrinsic value resulting in high correlation with the price move of the underlying asset.

Vega: Vega is a measure of sensitivity in the option price with respect to the change in volatility. Volatility and Option Prices (both Puts and Calls) have positive correlation and as a result are always +ve. However, as an option strategy might have positive or negative Vega. For example: A call spread strategy in Sterlite, buying a call with a Vega 2.5 and selling another call with Vega 3 might result in a Strategy Vega of (2.5-3.0) = -0.5. Options with highest time values have the highest Vega. That means in case of an OTM option, it is more sensitive to volatility than the underlying. This would mean that such options will have highest Vega

Theta: Theta is defined as a change in an option price with respect to change in time value. Thetas for all options are negative as options keep losing time value as one nears the expiry of the derivatives contracts. Like Vega, a strategy can have positive or negative Theta. The Thetas are highest for the ATM (at the money) options in the current series which is nearest to expiry.

Gamma: Gamma is basically the second derivative which measures the rate of change of Delta with respect to change in underlying. Delta, is a measure of a directional risk faced by any option strategy. So when a trader hedges his strategy for Delta, he also has to keep in mind the Gamma factor, as the option which has the highest Gamma is more subject to price move than with the option which has lower. Being second derivatives by nature, the Gammas are always positive. Only at strategy level, Gamma can turn negative.

An ideal option trading book will have the cumulative strategy Deltas equal to zero with the Gamma being Neutral.

Next time we would discuss how to use The Greeks to create strategies in market and The Greeks of different strategies.

(The author is Vice President - Research, Padmakshi Financial Services Ltd)

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