The price of an option can be affected by various factors that can either lead to benefit traders or hurt them based on which position they take. As a regular options trader, it is important to understand the factors that commonly influence pricing. This includes what is popularly known as “Greeks” – risk measures that are named after Greek letters denoting them.
The letters show how sensitive an option is as far as time-value decay, volatility, and price movements are concerned. The main Greek risk measures are called options vega, theta, gamma, and delta.
Understanding options contracts
Options contracts are mainly used for hedging a portfolio. The main objective is to balance potential and unfavorable moves in other types of investments. Options contracts can also be used for speculating about determining whether the price of an asset will rise or fall.
In other words, call options grants the person holding an option the right to purchase an underlying asset. A put option gives the holder of the option the right to sell the underlying asset.
Options can be converted to shares of assets that are underlying at a stipulated price known as the strike price. Besides, every option contains an ending date, popularly known as an expiration date.
Below are the factors that measure risk:
Delta basically measures how much the price of an option is predicted to change for every $1 shift in the price of an underlying index or security. For instance, a Delta of 0.40 implies that the price of an option will likely move $0.40 for every one-dollar change. Traders usually use Delta to determine whether the option in question will expire at the predicted time or not.
Whereas Delta is a snapshot when it comes to time, Gamma is used to measure the rate of change in an option of Delta over a specific period of time. To better understand this concept, you can view Gamma as acceleration and Delta as speed. Since Delta can’t go beyond 1.00, Gamma is reduced as an option and goes beyond ITM.
Theta options show a trader how much an option’s price will decrease per day as the option gets closer to its expiration date, provided all factors are kept constant. According to tastytrade, “Theta is the daily decay of an option’s extrinsic value.” This type of erosion in prices over a long period of time is referred to as time decay.
But you should note that time-value erosion is not direct, meaning price erosion or decline of ATM is just slightly out. As such, ITM can generally increase before the expiration date of the option.
Vega is the one that measures the rate at which an option changes in terms of price. Although Vega is not an actual Greek letter, its purpose is to show you how much the price of an option shows a shift when there is an increase in the volatility of an underlying asset.
As an options trader, understanding the various factors that influence the price of options is important.