While many of the terms used to describe buying and selling options are the same terms used to describe other investments, some are unique to options. Mastering the new language may take a little time, but it’s essential to understanding options strategies you’re considering.
What are Greeks in options trading?
The terms that estimate changes in the prices of options as various market factors — such as stock price and time to expiration — change are named after Greek letters, and are collectively known as the Greeks. Many investors use the Greeks to compare options and find an option that fits a particular strategy. It’s important to remember, though, that the Greeks are based on mathematical formulas. While they can be used to assess possible future prices, there’s no guarantee that they’ll hold true.
Greeks on stocks
When used to describe stocks, these measurements compare the stock’s performance to a benchmark index. Beta – a measure of how a stock’s volatility changes in relation to the overall market. A beta may help you determine how closely a stock in your portfolio tracks the movement of an index, if you’re considering hedging with index options. For example, a beta of 1.5 means a stock gains 1.5 points for every point the index gains — and loses 1.5 points for every point the index loses.
Alpha – a measure of how a stock performs in relation to a benchmark, independent of its beta. A positive alpha means that the stock outperformed what the beta predicted, and a negative alpha means the stock didn’t perform as well as predicted.
Two types of options volatility
Volatility is an important component of an option’s price. There are two kinds of volatility: historic and implied. Historic volatility is a measure of how much the underlying stock price has moved in the past. The higher the historic volatility, the more the stock price has changed over time. You can use historic volatility as an indication of how much the stock price may fluctuate in the future, but there’s no guarantee that past performance will be repeated.
Implied volatility is the percentage of volatility that justifies an option’s market price. Investors may use implied volatility to predict how volatile the underlying asset will be, but like any prediction, it may or may not hold true. Volatility is a key element in the time value portion of an option’s premium. In general, the higher the volatility — either historic or implied — the higher the option’s premium will be. That’s because investors assume there’s a greater likelihood of the stock price moving before expiration, putting the option in-the-money.
Open interest – the number of open positions for a particular options series. High open interest means that there are many open positions on a particular option, but it is not necessarily a sign of bullishness or bearishness.
Volume – the number of contracts — both opening and closing transactions — traded over a certain period. A high daily volume means many investors opened or closed positions on a given day.
Liquidity. The more buyers and sellers in the market, the greater the liquidity for a particular options series. Higher liquidity may mean that there is a demand for a particular option, which might increase the premium if there are lots of buyers, or decrease the premium if there are lots of sellers.
Greeks on options
When used to describe options, the Greeks usually compare the movement of an option’s theoretical price or volatility as the underlying stock changes in price or volatility, or as expiration nears.
A measure of how much an option price changes when the under lying stock price changes. The delta of an option varies over the life of that option, depending on the underlying stock price and the amount of time left until expiration. Like most of the Greeks, delta is expressed as a decimal between 0 and +1 or 0 and –1. For example, a call delta of 0.5 means that for every dollar increase in the stock price, the call premium increases 50 cents. A delta between 0 and –1 refers to a put option, since put premiums fall as stock price increases. So a delta of –0.5 would mean that for every dollar increase in the stock price, the put premium would be expected to drop by 50 cents.
The rate at which premium decays per unit of time as expiration nears. As time decays, options prices can decrease rapidly if they’re out-of the-money. If they’re in-the-money near expiration, options price changes tend to mirror those of the underlying stock.
An estimate of how much the price of an option — its premium — changes when the interest rate changes. For example, higher interest rates may mean that call prices rise and put prices decline.
An estimate of how much an option price changes when the volatility assumption changes. In general, greater volatility means a higher option premium. Vega is also sometimes referred to as kappa, omega, or tau.
Greeks on Greeks
Some Greeks work as secondary measurements, showing how a particular Greek changes as the option changes in price or volatility.
A measure of how much the delta changes when the price of the underlying stock changes. You might think of gamma as the delta of an option’s delta.
If you hedge an investment, you protect yourself against losses, usually with another investment that requires additional capital. With options, you might hedge your long stock position by writing a call or purchasing a put on that stock. Hedging is often compared to buying insurance on an investment, since you spend some money protecting yourself against the unexpected.
When you leverage an investment, you use a small amount of money to control an investment that’s worth much more. Stock investors have leverage when they trade on margin, committing only a percentage of the capital needed and borrowing the rest. As an options investor, you have leverage when you purchase a call, for example, and profit from a change in the underlying stock’s price at a lower cost than if you owned the stock. Leverage also means that profits or losses may be higher, when calculated as a percentage of your original investment.
Options Trading Glossary. Term and Definitions by Inna Rosputnia
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