Options are versatile investment tools that are used to manage the various risks associated with an investment. More conservative investors aim for minimal risk and more aggressive traders are willing to accept more risk in an attempt to earn more profits. Each adopts a different option strategy.
When dealing with options, it’s possible to measure and modify the risk of any stock market investment. You can take steps you deem necessary to offset as little, or as much, of that risk as desired. When calculating various risks, a set of Greek letters, collectively known as ‘the Greeks,’ are used to measure (or quantify) specific risks associated with an investment.
Let’s take a quick look at a few of the more important, and commonly used, Greeks: delta, gamma, theta, and vega. NOTE: Vega is not a Greek letter, but apparently that’s not an issue.
By calculating the delta, gamma, theta and vega of a position, specific risk parameters are measured, and thus, can be adjusted to suit the risk tolerance of the investor. Let’s take a look at the definitions of the individual options Greeks and in a later post we’ll examine how they are used by option traders.
- Delta measures the rate at which the price of an option changes when the underlying asset (stock, ETF or index) moves one point. Delta is not constant.
- Gamma measure the rate at which delta changes as the underlying moves one point.
- Theta measures the amount by which the value of an option decreases as one day passes. Thus, theta is ‘time decay.’
- Vega measures the sensitivity of the option’s price to a change in the implied volatility (IV), and represents the amount by which the option value changes when IV moves higher or lower by one point.
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Further Reading, Options: