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Options are very popular derivative assets that let investors benefit in various ways. In this article, we’ll discuss the so-called “greeks” and the options premium. Read on!
The Greeks
An option’s value consists of several elements that go together with the Greeks. These elements are:
- The price of the underlying security
- Expiration time
- Implied volatility
- The actual strike price
- Dividends
- Interest rates
The so-called Greeks provide important information regarding risk management, helping to rebalance portfolios to achieve the desired exposure. Each of them measures how portfolios react to changes in a particular underlying factor, enabling individual risks to be examined.
Delta
Delta measures the rate of change in the data in relation to changes in the underlying asset’s price.
Gamma
Gamma measures the rate of change in the delta in relation to changes in the underlying asset’s price.
Lambda
Also called elasticity, Lambda relates to the percentile variation in an option’s value compared with the percentile variation in the underlying asset’s price. This provides a way of calculating leverage, which may also be called as gearing.
Theta
Theta calculates the sensitivity of the value of the option to the passing of time. This is a factor known as “time decay.”
Vega
Vega measures the susceptibility to volatility. Vega is the gauge for the option’s worth with regards to the volatility of the underlying asset.
Rho
Rho measures reactivity of the option value to the interest rate. This is the measure of the option value with respect to the risk-free interest rate.
Therefore, if we use the Black Scholes Model, which is considered the standard model for valuing options, the Greeks are reasonably simple to determine, and are very useful for day traders and derivative traders.
The value of an option is directly affected by “time to expiration” and “volatility” where:
- A longer period of time before expiration usually raises the value of both call and put options. The opposite of this is also the case, in that a shorter period of time before expiration is apt to create a drop in the value of both call and put options.
- Where there is higher volatility, there is an increase in the value of both call and put options, while decreased volatility results in a decrease in value of both call and put options.
The price of the underlying asset has a different impact on the value of call options when compared to put options.
- Normally, as a security’s price rises, the corresponding straight call options follow this rise by gaining value, whereas put options slump in value.
- When a security’s price drops, the opposite is true, and straight call options usually experience a decrease in value, while put options experience an increase.
Options Premium
This takes place when a trader buys an options contract and pays an upfront amount to the seller of the options contract. This options premium will vary, depending on when it was calculated and which options market it is purchased in.
The premium may be different within the same market, depending on the following criteria:
- Whether the option is in or out-of-the-money.
- The time value of the contract
- Level of market
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