Successful trading in the options markets requires one to understand the quantitative logic behind how a particular underlying asset is priced by the market and compare that to its intrinsic value in order to take advantage of the difference between the two.
We know that the prices of options are determined by the Black Scholes formula that takes into account factors such as the price of the underlying stock, time for expiration of the contract as well as the implied volatility of the stock price.
Greeks as indicators measure the sensitivity of the prices of options with respect to these factors and help in advanced quantitative and statistical analysis.
With the changes in the price of an underlying stock or index, will the price of the options contract on the same stock/index also change? If so, by how much, and will the change be in the same direction?
Named after letters in the Greek language, Greeks help us understand the sensitivity of the options prices to changes in prices of the underlying stock/index and the factors affecting it.
- Delta: Delta measures the sensitivity or rate of change of an option’s price to that of the underlying stock. For example, for options contracts on the Nifty index, a delta of 0.4 indicates that if the Nifty index rises or falls by 1%, the options contract will rise or fall by (0.4 x 1%). Delta for call options range from 0 to 1 and delta for put options range from 0-1.
- Gamma: Gamma measures the sensitivity or the rate of change of an option’s delta with respect to the change in the underlying stock price. It is also known as the second-order derivative of the options contract. Even if the price of the Nifty index remains unchanged, if the option is in-the-money, the delta will be positive and will increase as the options nears expiration due to the rising Nifty volatility closer to expiry.
- Theta: Theta measures the exposure of the options price to the passage of time, i.e. the rate at which the options price changes as it approaches time to expiry. Theta is highest when closer to the expiry of an options contract.
- Vega: Vega measures the sensitivity of the options price to changes in the implied volatility of the underlying stock or index. Generally, options get more expensive as volatility rises. Vega is the highest for at-the-money options and tapers off on either side above or below the options strike price. Traders try to make profits when there is an increase or decrease in implied volatility of the options contract without change in the price of the underlying stock or index.
- Rho: Rho measures the sensitivity of the options price with respect to changes in interest rates. This is mostly relevant when the underlying is a bond rather than a stock, since bonds are more sensitive to interest rates. Rho increases when the time to expiration of the options contract becomes longer.
Thus, options are priced using the mathematical Black Scholes formula and Greeks help in the further understanding of these pricing models and to create profitable options trading strategies.