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What are the Option Greeks

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If you’re somewhat new to Options, you must have heard about the Option Greeks. In fact, a common rookie mistake with Options traders is that they ignore the Greeks. In this post, hopefully, I can convey the importance of Option Greeks explained in simple terms. This is easily one of the biggest mistakes a newbie Options trader can do. – PowerPoint PPT presentation

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Title: What are the Option Greeks

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What are the Option Greeks

Option Greeks explained
Author Hari Swaminathan

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About OptionTiger

If youre somewhat new to Options, you must have
heard about the Option Greeks. In fact, a common
rookie mistake with Options traders is that they
ignore the Greeks. In this post, hopefully, I can
convey the importance of Option Greeks
explained in simple terms. This is easily one of
the biggest mistakes a newbie Options trader can
do.
Youll find the Option Greeks explained in many
complicated ways youll find common
explanations for Delta as the amount an Option
price will change for a 1 move in the
underlying, and youll find similar explanations
for the other 3 main Greeks as well Gamma,
Theta and Vega. Let me try a slightly different
explanation here.
You are an airline pilot
Put yourself in the shoes of an airline pilot. A
pilot needs two sets of tools to fly the plane
safely from Point A to Point B.
1) The pilot needs a map to know where to go.
2) The pilot also needs a set of reliable
instruments to get from A to B.

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In the Options world, the map is the Profit
Loss diagrams, and various Options simulation
tools you have including the simulation of risk
graphs. You look at the risk graph and you get a
visual idea of where you need to go. You tweak
the simulation parameters to know how your
position will perform under different market
conditions like Price movement, changes in
Volatility or with the passage of time. You can
tweak one or all of these parameters and you can
see how these simulations impacts your Risk
Graph. This is the Map. Its visual. And you get
a clear visual idea of how to navigate your trade
by mentally setting various adjustments, and even
the nature of adjustments.
The second tool is a reliable set of instruments
that can get the plane from A to B. In the
Options world, this set of instruments are your
Option Greeks. Think of the four main Greeks as
the set of four key instruments available to you
as the pilot of your Options trade. If one of
these instruments has overshot some
pre-determined limits, you have to turn its knob
to one side to bring it back into the acceptable
limits. You do this for all four Greeks in an
effective manner, and youre actually guiding
your plane safely to your destination. This
analogy is very true You can control every
aspect of your Option position simply by tweaking
the four Greeks. You dont even need to look at
what the markets or your stock is doing. You can
manage your adjustment points, and once you
become an expert, you can navigate your Options
plane on auto-pilot. Hopefully, you have a
better appreciation for how important Option
Greeks are.

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But what exactly are the Option Greeks ? What do
they measure ? And why is it the case that these
obscure terms can have such control on whats
going on in the markets ?
The key lies in the fundamental facts about what
Options are, and how the Black Scholes Options
pricing model was invented. Youve probably
heard before that Options are a mathematical
concept. Buyers and sellers barter rights and
obligations. There is no underlying security that
is actually traded, you only trade contracts with
rights and obligations that are based on an
underlying security like shares of a stock. All
Options also have an expiry date of some time in
the future. Options do cost money, so there is a
cost of carry of these rights and obligations.
The opportunity cost of this capital is dependent
on the prevailing interest rate environment. And
because Options have an expiry date, they must
lose some value as time passes. And once again,
because of this expiry date, you have to ask this
question Within a certain amount of time, what
is the probability of a certain stock reaching a
certain price (strike price of the option). To
answer this question on probability, you need to
know the Volatility of the stock, with
Volatility being defined in standard deviation
terms based on that stocks historical stock
prices (say past 12 months).

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So pricing an Option has to consider all these
elements. The inventors of the Black-Scholes
formula had to consider all these elements.
(Notice I used the word formula in this
sentence). And this is the key. Everything in
Options pricing is a formula. The way an Option
responds to price movement of the underlying
stock is a formula. The way it responds to
passage of time is a formula. The way it responds
to changes in Volatility is also a formula and so
on and so forth with interest rates, cost of
capital etc. So everything is a formula. Options
are a truly mathematical concept, and the price
of an Option has many components to it, and each
of its components responds to one or more of
these parameters.
In the case of response to changes in the
underlying price of the stock the Greeks are
Delta and Gamma
Sensitivity to the passage of time is measured
by the Greek Theta.
Sensitivity to changes in Implied Volatility is
measured by Vega.
Interest rates is Rho..and so on.

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And each one of these Greeks are calculated by a
formula from the Black Scholes model. Because of
this fact, we can manage the entire options
position simply by managing the Greeks. Imagine
yourself looking down upon an instrument panel
with these four main instruments. And in front of
you is the market, but youre not looking at the
market because youre looking down at your
instrument panel which is getting a real-time
feed of whats going on in the markets, by way of
changing Option prices. The Greeks are changing
because of the change in Option prices, and all
youre doing is managing your Greeks, and
navigating your trade to success. You can be
oblivious of everything else. Thats how
powerful Option Greeks are.

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