Introduction To Stock Option Pricing and the Greeks

Option Prices Are Effected By Several Factors Called The Greeks, And It Is Critical You Understand What They Are.

Options are derivative securities. They derive their value from some underlying security or index and their price is affected by a number of factors. Because of their derivative nature, they behave differently than the underlying security and their price will not necessarily respond as you might first expect.

The factors that affect an option’s price are collectively referred to as the “Greeks.” Each factor has been assigned a Greek letter, or what sounds like a Greek letter, as a short hand for some force that operates upon the value of an option contract.  Learning the greeks, and how they influence stock option pricing, will give you an insight that is fundamental to your success as an option trader.

Delta - Directional Change

Delta is a measurement of the rate at which an option’s price will change given a one dollar increase (or decrease) in the underlying security’s price. For example, an option with a delta of 20 will increase .20 cents in value if the underlying stock increases by $1.00. To complicate matters further, an option's delta changes during the life of the option contract and will change as the price of the underlying security changes.

Delta also measures the equivalent number of shares of stock you may be long or short in the market and is an excellent gauge of risk.  If your option position has a delta of -100, it is the equivalent of being short 100 shares of stock.  Purchasing 100 shares of stock would neutralize delta, reducing it to zero.

Gamma - The Speed Of Change

The delta of an option is not static. Delta changes with the change in the share price of the underlying stock. That change is measured by the "gamma" of the option. Gamma references the anticipated change of the delta, for each incremental change in the price of the underlying stock.

Rho - Risk Free Return

We always have an alternative investment for our money. One of the alternatives is to earn a "risk free" rate of return, which is usually associated with government debt securities. The risk free return is referred to as "Rho."

Theta - The Passage Of Time

Theta measures the amount of value that is lost from an option due to the passage of time. Options have limited life spans. They are what might be referred to as a wasting asset. The rate at which value decays or is lost from the option is expressed as Theta.

Vega - Volatility

Vega describes the level of implied volatility in an option. Options become more expensive in volatile markets. As the markets become more volatile, they also become more uncertain creating emotions of fear and greed in market participants. Those emotions may motivate a participant to pay more for a put option to protect his or her portfolio from a market drop. With little change in the price of the underlying stock, a change in volatility or Vega can have profound consequences, positive and negative, upon an option position.

Learn The Option Greeks Or Struggle

Developing An Understanding Of Option Pricing Each of these factors effect the valuation of the options you have bought and/or sold. Until you grasp the concepts embodied in these “Greeks”, you will struggle to understand why your trades act in seemingly erratic fashions and you will encounter increasing difficulty as you delve into more advanced options positions.

These concepts will begin making sense as you start working with advanced option strategies. The simplest strategy you can employ is the outright purchase of a call or a put. Even those simple “one legged” positions will respond to the differing forces of delta, vega and theta. As you begin adding additional legs, i.e., different option contracts, to the position, those forces will be decreased or magnified. By adding or removing additional legs to the trade, you can exert control over how your position will respond to market changes.

Of course, if you do not understand how to manage the greeks, you will face a very difficult time adjusting or repairing your option trades. 

Recommended Resources

Options Mastery Course
The Options Mastery Course was developed by former
options floor trader Ron Ianieri.  This review explains
the course's strengths and why we recommend it.

Mastering Option Trading Volatility Strategies
Sheldon Natenberg, on DVD, outlines a step-by-step
approach to understanding the key role volatility plays
for becoming a consistently successful options trader.

Option Volatility & Pricing, 2nd Edition
Updated edition tells you how to identify mispriced
options and construct volatility and "delta neutral"
spreads used by the pros.