What Are Option Greeks...And Why They Are Important

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In any position, whether purchasing a CALL or entering a multi-leg trade, you can estimate a set of risk parameters known as ‘option greeks.’ Each option contract has its own collection of greeks which can be added arithmetically with other option greeks that cover the same underlying asset. As positions become more complex, traders pay close attention to these hedging parameters to ensure there is not excessive risk from changes in underlying asset price, implied volatility, time erosion, and interest rates.  

Suppose you buy an option contract on SPY with a delta of 70. What does that mean?  It is actually really simple.  It means that if SPY goes up $1, then the value of the contract you bought will appreciate by $70, holding everything else constant.  Conversely, if SPY drops by $1, then the position value will depreciate by $70.

When SPY moves $2, will your position appreciate by $140? No. This can be explained by the second risk parameter commonly referred to as gamma.  Gamma measures how much the delta changes with movements in underlying asset price.  If gamma is positive, then you would expect a positive $2 move in the price to benefit the position by more than $280 ($140 X 2).  Once again this was because gamma, the partial derivative of delta (second derivative with respect to price), is positive.

The third parameter is vega, which is a measurement of the option contract’s sensitivity to changes in implied volatility.  This is important to note because a change in implied volatility will directly affect an option contract price.  A positive vega means that your position will appreciate from an increase in implied volatility, and a negative vega will appreciate from a decrease in implied volatility. Buyers are long volatility (positive vega) and contract sellers are short volatility (negative vega).

The fourth risk parameter is theta, which is the measurement of the option contract’s sensitivity to daily time decay. It can either work for or against you.  Most inexperienced traders end up purchasing time premium from sellers because they are hoping to hit a home run. However, selling premium (positive theta) means that even if the stock stays flat you’ll still win as the value of the position appreciates with time.

The fifth risk parameter is rho, which is simply sensitivity to interest rate risk. Typically for retail traders, this parameter is ignored. There is more of an emphasis on other parameters that impact day-to-day prices more consistently.  Below is a chart of the major risk parameters and how they are all related.  In order to have success as an options trader, you’ll need to have an intuitive understanding of how the greeks relate to one another.