The Greeks in options trading are the values that help quantify and understand the risk and potential changes in the value of options contracts. They may sound complicated, but you can make the interpretation of Greeks as complicated or simple as you’d like.
The options Greeks are Delta, Gamma, Theta, Vega, and Rho. Each Greek contributes to the multiple inputs that the Black-Scholes model takes into account to price options.
Delta measures how much an option’s price will change for a $1 move in the underlying stock. For call options, delta ranges from 0 to 1, indicating the probability of the option expiring in-the-money. Conversely, put options have a delta of -1 to 0. A delta of 0.5 suggests that the option’s value will increase by $0.50 for a $1 increase in the stock price.
When day trading options, Trade Brigade traders aim to take positions on options contracts with a 0.4-0.6 positive or negative delta. Oftentimes this delta range will put the option right at the money. Remember that delta works both ways, so if the underlying moves $1 against you, you’ll lose the value of one delta on your options value. Being in this sweet spot of 0.4-0.6 will give the best upside on a directionally correct trade but cushion the blow on a directionally wrong trade.
An easy way to remember delta is that ‘D’ for delta correlates to the gain or loss on a 1 ‘D’ for dollar move on the underlying.
Gamma represents the change in an option’s delta for a $1 change in the underlying stock. It measures the sensitivity of delta, reflecting how quickly delta changes as the stock price moves. Gamma is higher for at-the-money options, making them more responsive to price fluctuations.
The reason Trade Brigade traders like the at-the-money options is for this exact reason. If we are right, we will have strong tailwinds, if we are wrong, delta will diminish from an already neutral place. This is not a number that needs to be evaluated for every trade, rather just a concept thats understood before getting involved in options trading.
An easy way to remember gamma is that ‘G’ stands for gasoline being poured on the fire.
Theta, often referred to as “time decay,” indicates the loss of an option’s value due to the passage of time. Traders who sell options benefit from theta decay, as they aim to profit from diminishing premium value over time.
Trade Brigade traders often trading in the shorter time frames aim to trade same week expirations Monday – Wednesday and go to the following week’s expiration when Thursday and Friday’s sessions begin. The reason behind this is to provide some cushion as we approach the end of the week. When trading options close to expiration theta will be more aggressive compared to options with longer dates until expiration.
Theta is an easy one to remember because ‘T’ stands for time decay.
Vega indicates an option’s sensitivity to changes in implied volatility. It measures how much an option’s price will change for a 1% change in implied volatility. High vega implies that options are more sensitive to volatility changes, making them potentially more expensive. Vega is the factor that drives options prices up as we approach key economic events. The most obvious examples are in the options that expire the same week a company reports earnings.
Trade Brigade traders do not trade around earnings reports to avoid the implied volatility crush effect. Before earnings, implied volatility makes options contracts more expensive on the premise that a large move can come from any surprises in the report. Being efficient, options price in outsized moves with vega. When the report comes out and the move is known, the implied volatility will get sucked out of the contract, and thus dramatically decrease its value. Oftentimes it is not worth getting involved in these binary events.
Vega is easy to remember with ‘V’ standing for volatility.
Rho gauges how much an option’s price will change for a 1% change in interest rates. While rho’s impact on option prices is generally smaller compared to other Greeks, it’s particularly relevant for longer-term options. An increase in interest rates usually boosts call option prices and depresses put option prices.
This concept is useful to know, but does not need to be considered when day trading options. Interest rates (unless the day of FOMC decision) are going to be stable. Trade Brigade traders do not factor this into analysis when selecting an options contract to trade.
Rho is an easy one with ‘R’ standing for rates.
There is no end to the amount of impact that the greeks can have on the pricing of options contracts. You have to remember that all of these greeks are acting on the pricing of the contract at all times. Before getting overwhelmed, think about what your timeframe of execution is for the trade idea that you have in the pipeline. If your trade idea is a day trade, you should only be concerned with delta and theta.
The Trade Brigade strategy is to pick a contract that is near the money and to trade Friday’s expiration on Monday – Wednesday, and then flip to the following Friday expiration on Thursday and Friday. Now that you know what the greeks are and how they impact options pricing you can make the decision about what will best suit your strategy and needs.
For swing traders, it’s likely wise to consider how much theta will impact your idea if you are wrong on timing. The tricky part about options is that although they are leveraged, you are betting against time by being net long options in your position. You may also consider vega when you have a longer time horizon just to think about how any earnings announcements in the middle of your trade window could impact pricing.
Being armed with the tools to understand what the greeks are is incredibly important, but just remember that you don’t have to have a PhD in mathematics to come to a logical conclusion about what options you should be trading, especially if you are executing in shorter time frames such as day trading.