6.

Option Greeks

ECO4108Z
10th September 2024

Dr Ayesha Sayed
Senior Lecturer (Finance)
Department of Finance and Tax
University of Cape Town
 DELTA GAMMA THETA VEGA

Option Greeks refer to a set of calculations you can use to measure

• Delta measures how much an option's price can be expected to move for every $1 change in the price
of the underlying security or index. For example, a Delta of 0.40 means the option's price will
theoretically move $0.40 for every $1 change in the price of the underlying stock or index. The higher
the Delta, the bigger the price change.

• Traders can use Delta to predict whether a given option will expire ITM. So, a
Delta of 0.40 is taken to mean that at that moment in time, the option has about
a 40% chance of being ITM at expiration.

• Call options
– Call options have a positive Delta that can range from 0.00 to 1.00.
– At-the-money options usually have a Delta near 0.50.
– The Delta will increase (and approach 1.00) as the option gets deeper ITM.
– The Delta of ITM call options will get closer to 1.00 as expiration approaches.

• Put options
– Put options have a negative Delta that can range from 0.00 to –1.00.
– At-the-money options usually have a Delta near –0.50.
–
 GAMMA
• Gamma, helps you estimate how much the Delta might change if the stock
price changes.

• Gamma measures the rate of change in an option's Delta over time.

• Gamma is useful for determining the stability of delta, which can be used
to determine the likelihood of an option reaching the strike price at
expiration.

• If an option has a delta of .40 and a gamma of .05, the premium would be
expected to change $0.40 with the first $1 move in the underlying. Then,
to figure out the impact of the next dollar move, simply add delta and
gamma together to find the new delta: .45.
 THETA
• Theta, helps you measure how much value an option might lose each day as it
approaches expiration

• Theta tells you how much the price of an option should decrease each day as the
option nears expiration, if all other factors remain the same. This kind of price
erosion over time is known as time decay.

• Time-value erosion is not linear, meaning the price erosion of at-the-money (ATM),
just slightly out-of-the-money, and ITM options generally increases as expiration
approaches, while that of far out-of-the-money (OOTM) options generally
decreases as expiration approaches.

• Theta estimates how much value slips away from an option with each passing day.

• If an option has a theta of negative .04, it would be expected to lose $0.04 of value
every day.
 VEGA
• Vega, helps you understand how sensitive an option might be to large price swings in the
underlying stock.

• Vega measures the rate of change in an option's price per one-percentage-point change in
the implied volatility of the underlying stock.

• A drop in Vega will typically cause both calls and puts to lose value.

• An increase in Vega will typically cause both calls and puts to gain value.

• There are a lot of factors that could cause a spike in implied volatility: earnings
announcements, political conditions, and even weather. Depending on the strategy you
choose, a spike in volatility could be a blessing, a curse, or have a very small impact. And the
further out an options expiration is, the higher its vega will be. In other words, options with a
longer expiration may react more to a change in volatility.

• If an option has a vega of .03 and implied volatility decreases one percentage point, the
premium would be expected to drop $0.03.
 RHO
• Rho, helps you simulate the effect of interest rate changes on an option. Rho measures the
expected change in an option's price per one-percentage-point change in interest rates. It
tells you how much the price of an option should rise or fall if the risk-free interest rate (U.S.
Treasury-bills)* increases or decreases.

• As interest rates increase, the value of call options will generally increase.

• As interest rates increase, the value of put options will usually decrease.

• For these reasons, call options have positive Rho and put options have negative Rho.

• Assume a call option has a rho of 0.05 and a price of $1.25. If interest rates rise by 1%, the
value of the call option will increase to $1.30, all else being equal. The opposite is true for put
options
• Now, let's pull our Greeks together and look at how they can be used to analyze the
sensitivities of a single option. To set the stage, let's say your options premium is $1.30. And
your option has a delta of .35, gamma of .06, theta of .02, and vega of .07.
• Today, price moves from $45 to $46, and the premium increases $0.35 to $1.65. Because a
day has passed, the premium decreases $0.02 due to theta.
• Tomorrow, price moves from $46 to $47. The premium increases $0.41 to $2.04; this is delta
plus gamma.
• Also, another day gone by, means another day of time decay, and another $0.02 down the
drain.
• Implied volatility rises one percentage point, increasing the premium by $0.07 to $2.09.
• Putting all these factors together shows how a relatively small change in the underlying can
lead to a pretty significant change in the options premium.