How to Use Option Greeks to Measure Risk - SmartAsset

Trading options is something you might consider if you’re interested in providing you’re an active trader. This speculative investment strategy involves buying the right to buy or sell a security, rather than purchasing the security itself. Before venturing in, it’s helpful to get to know the option Greeks. The “Greeks,” which are named after various letters of the Greek alphabet, represent different ways to measure risk when trading options. This primer to the option Greeks can help you better understand how they work and how to use them when making investment decisions.

Trading options is something that requires preparation and planning. That’s where a financial advisor can offer invaluable guidance.

What Is an Options Contract and How Does It Work?

To understand the option Greeks, it helps to first take a closer look at how options contracts work. Again, an option is simply the right to buy or sell a particular security.

A call option represents an investor’s right to buy a set number of shares of a security, as outlined in the options contract, at a certain price. This is called the strike price. A put option is the right to sell shares in an options contract, again at the strike price.

When making (or “writing”) call or put options, an investor is essentially making calculations or educated guesses about how a security’s price will move. Investors can realize profits when exercising options if those assumptions play out. In that sense, an options contract is essentially a type of leverage since you’re not actually buying or selling anything.

Options contracts have expiration dates, which represent a deadline for exercising the option. Part of knowing when to exercise an option depends on understanding how the premium works. The premium is the amount an investor pays for an option and it’s based on both time value and intrinsic value.

Intrinsic value is how much an option is worth if you exercise it right away. It’s calculated as the difference between the option’s strike price and the underlying security’s current market value. Time value is the amount investors will pay above intrinsic value if they believe the investment will be profitable.

So what does all this have to do with option Greeks? In simple terms, the Greeks are used alongside pricing models to help options traders identify risk.

Option Greeks, Explained

A Greek refers to one of several terms that are used when evaluating risk in option positions. The Greeks work together to help option traders make informed choices when managing their portfolios.

Each Greek measures a different degree of risk. The Greeks can be divided into major and minor, with major Greeks being used most often. The most commonly used Greeks are delta, gamma, rho, theta and vega. Minor Greeks include epsilon, lambda, vomma and zomma, though you typically won’t see these discussed as often among options traders.

Here’s a closer look at how the major option Greeks work.

Delta

Delta is used to measure changes in an option’s price that stem from changes in the underlying security. Specifically, delta measures the rate at which an option’s price changes relative to a $1 change in the price of the underlying asset. Whether delta is positive or negative depends on whether the option is a call or put.

With call options, premiums and asset prices move in tandem. If the underlying security’s price increases then the call premium increases and vice versa. With put options, premiums and asset prices move in opposite directions. So if the underlying security’s price declines, the put premium increases.

Delta can be useful for gauging when an option is likely to be in the money at the expiration date. Being in the money on a call option means you can buy a security for under its current market price. Delta can also be used to balance risk and rewards. A higher delta can mean more risk but better returns while a lower delta can signal lower risk with lower returns.

Gamma

Gamma is an option Greek that measures changes in delta over time. As delta shifts according to changes in the underlying security’s price, investors can use gamma to track the rate of change. This is important for evaluating how likely an option is to reach its strike price by the time the option expires. Again, this is a way to measure risk when trading options. If gamma is high, then the risk may be higher as well since it could be a sign of increased volatility to come. Low gamma, on the other hand, can signal lower risk and less volatility.

Gamma is also higher for options that are closer to being at the money. At the money means the strike price and current market value are the same. As options shift to being in the money or out of the money, gamma becomes lower.

Rho

Rho is used for measuring how sensitive an option is to fluctuations in interest rates. Specifically, it measures the rate of change between a 1% shift in interest rates and an option’s value.

When interest rates increase, call options usually see their value increase while put options usually decrease in value. In other words, rho is positive for call options but negative for put options.

Out of all the option Greeks, rho may have the least impact when interest rates are low unless a significant change in interest rates is anticipated. As interest rates start to climb, pricing gaps between call and put options may begin to expand.

Theta

Theta is used to measure how an option’s value or price is eroded over time. As an option draws closer to its expiration date, erosion can happen more quickly since the window for investors to make a profit begins to shrink.

When an option is purchased, the countdown to expiration begins and as such, so does a decline in the option’s value. If you’re buying options, you can use theta to decide when to exercise the option or whether to do so at all, based on how quickly value is flowing out.

Vega

Vega allows you to measure changes between option values and implied volatility associated with the underlying asset. Implied volatility means how likely an asset or security is to experience volatility in the future. When an option is perceived as being more susceptible to volatility, that generally translates to higher premiums.

In terms of scale, vega measures changes in an option’s price based on a 1% change in its implied volatility. What’s important to remember is that vega can shift based on changes in implied volatility alone, not any changes to the price of the underlying asset. The closer an option gets to its expiration date, the more vega declines.

The Bottom Line

Options trading is a little more advanced than buying and selling stocks or mutual funds. While options can be riskier than other types of trades, there can also be the potential for much higher rewards as well. Greek letters are commonly used in the investment community to represent different ways to measure and mitigate risk when trading options. Learning the option Greeks lingo can help you better navigate options trades and the associated risks.

Tips for Investing

Consider talking to a financial advisor about the pros and cons of options trading and how to decipher the option Greeks. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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