Option price or you can say the premium of the option is mainly affected because of the change in the spot price of the underlying security or the index. But there are various other factors that also impact the price of options like demand and supply of the option contract, sentiments of the traders, market condition, volatility and the time period of an option contract.
Option Greeks are other key important factors that not only affect the option price but also can tell you how they impact the option trades. Delta, Gamma, Theta and Vega also known as option Greeks used to measure the price change of options. Here we are going to discuss about this option Greeks and how they impact the trades in the option market.
Topics Covered :
- What is Delta in Options Trading?
- How Delta Affects Option Price?
- What Does Gamma Mean in Options?
- How Gamma Affects Option Price?
- What is Theta in Option Greeks?
- How Theta Impacts Option Trades?
- What is Vega in Options and How it Impacts Trading?
- Wrapping up
What is Delta in Options Trading?
Delta is used to measure the change in the price of the option (of course premium) with respect to the 1 point or unit change in the price of the underlying security. Suppose Delta of an underlying security is 0.70, it suggests, that when the price of the underlying security will change by 1 point, then the option premium of the same underlying security will change by 0.70 point or unit.
The call option is affected by the positive delta, while for a put option, -0.70 means, that every 1-point change in the price of the underlying security will lead to a decrease of 0.70 points or unit in the price of the option premium of the same underlying security.
How Delta Affects Option Price?
The value of Delta affects the call and put options differently and the strike price of the option contract is the major factor in how Delta affects the option premium. Usually, at-the-money options the value of the Delta is around 0.50.
However, Delta for the out-of-the-money options remains at lower levels maybe around 0.20, while Delta for deep-in-the-money stays at higher levels, somewhere around 0.80 levels. Compared to at-the-money, deep-in-the-money or out-of-the-money the option premium price fluctuates much slower. Hence the Delta is lower in such options.
As much the difference between the spot price and strike price, the Delta value will be low, and the lower Delta value means the option price will also be affected less on every point of change in the price of the underlying security.
What Does Gamma Mean in Options?
Delta will let you know the rate of change in the option price, while Gamma measures the speed of change or how rapidly Delta changes when the price of the underlying security changes.
If the value of Gamma is high, it means the Delta is highly sensitive, which will make the option price more volatile. However, if the value of the Gamma is low it shows the Delta will change slowly which will also make the price of the option less volatile.
How Gamma Affects Option Price?
Gamma quantifies the speed of change in the delta for each one-unit price change in the underlying security. Unlike delta, gamma always remains positive for both call and put options. But the gamma will be higher for at-the-money options and that gradually comes down for both in-the-money options and out-of-the-money options.
Gamma shows the intensity of how Delta reacts to 1-point change in option price. Not like, Delta Gamma stays positive for both call and put options. However, Delta not stays constant and can’t be greater than 1.00, while the Gamma value declines, when the option moves to the in-the-money and Delta touches 1.00.
The impact of Gamma is in terms of making the option price highly volatile when Gamma is high, while lower Gamma slowdowns the speed of change in Delta making the option less volatile. When the option contracts are near the date of expiry, the Gamma reaches the highest levels, but when the expiration date is long days away, Gamma stays at normal or at the lower side.
With the decrease in the Gamma value, options price also get affected, and when touches the 0 levels, the option becomes deep-in-the-money and Delta becomes 1. Nevertheless, despite the increase in the Gamma value, the buying cost option premium decreases that is because of Theta, as time passes or approaches towards expiry. Near the expiry the option premium loses its time value, so let’s talk about Theta in the next para.
What is Theta in Option Greeks?
Theta in option Greeks is that important factor that will tell you how much or at what speed the value of option premium decreases with the option contract reaching to expiry. This erosion of option premium price is better known as the time decay.
In option trading, time decay is good for the option sellers and bad for the option buyers, as the option premium price decreases each day approaching expiry while other factors remain constant. And Theta will show you how much the price of the option will be reduced each day.
How Theta Impacts Option Trades?
When you consider other factors that remain constant, the option premium price starts falling with each day coming near to expiry, due to time decay option price loses its value. This time decay is an enemy for the option buyers, while for the option sellers, it is like a friend.
As time passes each day, theoretically there is less time left for the underlying security to move in the direction, so that option premiums can become profitable trade for the option buyers. For at-the-money options, Theta is lower compared to out-of-the-money options.
Apart from the time decay, the option price is also affected due to volatility in the price of the underlying security. To understand how much volatility affects the option price, you have to move to the next section which will be about another member of Option Greeks, called Vega.
What is Vega in Options and How it Impacts Trading?
The volatility levels of an underlying security in option trading are measured by the Vega. If Vega is high, it shows the price of the option is more sensitive towards the change in the volatility. However, when the value of Vega is low, it shows the option price is less sensitive towards the change in the volatility of the underlying security.
As the Vega measures the volatility, and when implied volatility increases, the option price also increases that is because there is a higher chance of movement of the underlying security. While on the other hand, when the volatility decreases, the option price value also comes down.
Let’s talk about how Vega impacts the option trades or you can say affecting the call and put options. Though, the call and puts are affected in the same manner due to changes in the implied volatility, the impact is higher on the call options compared to put options.
While the option premium of out-of-the-money and in-the-money options the change in the volatility is much higher. With the expiration date nearing, the value of Vega also cools down as the underlying security price edges towards the option strike price.
Wrapping up
These option Greeks are important to know if you are an option trader. These option Greeks measure or show how the price of the option premium is changed due to a change in the price of the underlying security. The rate of change, sensitivity levels of change, time decay and volatility factors affect the option premium.
Delta will tell you how the option price changes with respect to the change in the spot price of the underlying security. The Gamma will express the speed of change in Delta and Theta will show you the rate of change in option price with the time decay. Finally, the Vega will help you to know how volatility in the price of the underlying security that affects the price of the options.
Knowing about these options Greeks will help you to choose the right option strike price and trade with low risk. However, there are various other factors that affect the option price like choosing the right trading platform and trading with the right option strategy as per the market conditions. You can find here at Religare, the best online trading app for options at the lowest brokerage charges.
Recommended Read: How to use Delta in Options Trading
Learn More About Derivatives Trading