The Five Greeks of Options

Just got back from Vancouver, in town for three days and then off to Newfoundland on Friday morning to complete my Canadian coast-to-coast tour. :)

You may have heard people talking about the “Beta” of a portfolio before, but option pricing sensitivity takes into account many more letters of the Greek alphabet: Delta, Gamma, Vega, Theta and Rho. Here is a brief explanation of each – and I will expound on them in the future in separate posts.

All five “Greeks” are factors that affect option contract theoretical values:

Delta: Is the amount of change in the theoretical value of the option contract for every $1 change in price of the underlying stock.

Gamma: Is the amount of change in the Delta for every $1 change in price of the underlying stock. So in other words, it is the rate of change in Delta (similar to how acceleration relates to speed – acceleration is the rate of change of speed).

Vega: Is the amount of change in the theoretical value of the option contract for every 1% change in the volatility estimate of the underlying stock.

Theta: Is the amount of decay in the price of the option contract for a given period of time. For example you would see data for 7-day Thetas which would measure how much of the change in price of the contract was due to time decay over 7 days.

Rho: Is the amount of change in the price of the option for every 1% change in interest rates. If interest rates go up, it makes owning call options more attractive and owning put options less attractive. It’s not the easiest of concepts to understand but if you were trying to decide between selling short a stock or owning a put option (both profit when the stock goes down), you would be more inclined to short the stock in a higher interest rate environment since your short proceeds would earn more interest.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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