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The price of options can fluctuate depending on several factors that can benefit or hurt your bottom line. Successful traders understand the factors that influence pricing, and one of these involves the Greeks.
Named after letters in the Greek alphabet, Greeks measure the options’ risks and decipher the sensitivity to certain variables. These variables are represented by the following Greek letters: delta, gamma, theta, vega, and rho.
Beginning traders might believe that when a stock moves $1, the options price should increase by more than $1. That’s false because the option costs less than the stock.
So what would the price of the option be in this case? That’s where delta comes into play. Delta represents the amount the options price should move based on the stock’s change.
The number usually appears as a decimal and can be negative or positive, depending on whether it’s a call or put option.
For gamma, it’s the rate at which delta will change based on the stock’s price. If you look at delta as how fast the price changes, gamma represents how quickly the price accelerates.
High gamma options are ideal as a buyer as long as your forecast is correct because your delta will increase. However, high gamma options as a seller are detrimental if your forecast is correct since the option will lose value quicker.
Gamma can be beneficial to use because its value can change over time, and gamma can help determine how stable delta is.
Theta represents the price of calls and puts that will decrease over one day. It works against the buyer but for the seller.
When looking at options, time is not beneficial since each moment that passes causes the time value to decrease. Not only does the value decrease, but as the option gets closer to expiration, its time value does so at an accelerated rate.
Vega represents the amount that the call and pull prices will change if a one-point change in implied volatility occurs. It doesn’t have a direct effect on the value of the options; rather, it affects the time value of the price.
Usually when the implied volatility increases, the option value increases. That happens because an increase in implied volatility means there’s an increased range with the stock’s movement.
For instance, consider a 30-day option on a stock that has a $50 strike price and a price of $50. With this option, vega might be .03. So the value of this stock might increase $.03 when the implied volatility increases one point. The option over 30 days would be $1.50.
Rho is used more with advanced traders, but it’s important to know what it represents. It signals the amount an option value changes based upon a 1% change in interest rates.
Rho doesn’t really affect short-term options, but if you’re trading long-term options, it comes into play more often.
Investors use the Greeks to evaluate the risk of different options. By understanding what they represent, you can help increase your hard-earned income by investing in options.
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