Delta
Delta is a measure that can be used in evaluating buying and selling opportunities. Delta is the option’s sensitivity to changes in the underlying stock price. The delta of an option ranges in value from 0 to 1 for calls (0 to -1 for puts). It measures the expected price change of the option given 1 point change in the underlying. Far out-of-the-money options have delta values close to 0 while deep in-the-money options have deltas that are close to 1.
As the delta can change even with very tiny movements of the underlying stock price, it may be more practical to know the up delta and down delta values. For instance, the price of a call option with delta of 0.5 may increase by 0.6 point on a 1 point increase in the underlying stock price but decrease by only 0.4 point when the underlying stock price goes down by 1 point. In this case, the up delta is 0.6 and the down delta is 0.4.
Delta can be used to evaluate alternatives when buying options. At-the-money options have deltas of roughly .50. This is sensible, as statistically they have a 50 percent chance of going up or down. Deep in-the-money options have very high deltas, and can be as high as 1.00, which means that they will essentially trade 1 point for 1 point with the stock. Deep out-of-the-money options have very low deltas and therefore change very little with 1 point move in the underlying. Some traders use these as stock substitutes, though there are clearly different risks involved.
Theta
Theta is the option’s sensitivity to time. theta is a measurement of the option’s time decay., giving us the points decay per day. The theta measures the rate at which options lose their value. This amount increases rapidly, at least in terms of a percentage of the value of the option, as the option approaches expiration. The greatest loss to time decay is in the last month of the options life. The more theta you have, the more risk you have if the underlying price does not move in the direction that you want.
For Example: A call option with a current price of Rs.1 and a theta of -0.05 will experience a drop in price of Rs. 0.05 per day. So in two days’ time, the price of the option should fall to Rs. 1.90.
Option sellers use theta to their advantage, collecting time decay every day. The same is true of credit spreads, which are really selling strategies. Calendar spreads involve buying a longer-dated option and selling a nearer-dated option, taking advantage of the fact that options expire faster as they approach expiration.
Gamma
The gamma metric is the sensitivity of the delta to changes in price of the underlying asset. Gamma measures the change in the delta for a 1 point change in the underlying. This is really the rate of change of the options price, and is most closely watched by those who sell options, as the gamma gives an indication of potential risk exposure if the stock price moves against the position.
Like the delta, the gamma is constantly changing, even with tiny movements of the underlying stock price. It generally is at its peak value when the stock price is near the strike price of the option and decreases as the option goes deeper into or out of the money. Options that are very deeply into or out of the money have gamma values close to 0.
For Example: Suppose for a stock XYZ, currently trading at Rs 47, there is a DEC 50 call option selling for Rs. 2 and let’s assume it has a delta of 0.4 and a gamma of 0.1 or 10 percent. If the stock price moves up by Rs. 1 to Rs. 48, then the delta will be adjusted upwards by 10 percent from 0.4 to 0.5. However, if the stock trades downwards by Rs. 1 to Rs. 46, then the delta will decrease by 10 percent to 0.3.
Vega
Vega is the option’s sensitivity to changes in implied volatility. A rise in implied volatility is a rise in option premiums, and so will increase the value of long calls and long puts. Vega increases with each expiration further out in time.
Options tend to be more expensive when volatility is higher. Thus, whenever volatility goes up, the price of the option goes up and when volatility drops, the price of the option will also fall. Therefore, when calculating the new option price due to volatility changes, we add the vega when volatility goes up but subtract it when the volatility falls.
Rho
Rho is the option’s sensitivity to changes in interest rates. Most traders have little interest in this measurement. An increase in interest rates decreases an options value because it costs more to carry the position.
