If you are interested in trading and investing stocks, you might have heard the Greeks mentioned once or twice and may be wondering who or what these Greeks are.

The Greeks are just the name given to the quantities representing the sensitivities of the price of derivatives to a change in the parameters on which the value of the instrument is dependent. In other words, the Greek are a way of measuring risk management. Each Greek will measure the sensitivity of the value of the portfolio to ONE small change in a given parameter. This is an extremely useful tool in risk management because when it allows for each risk to be dealt with separately and therefore the whole portfolio can then be rebalanced accordingly.

The Greeks are a product of the Black-Scholes model. This is a mathematical model of a financial market which is used for pricing equity options. The model is designed to price an option as a function of certain variables. Before the Black-Scholes model was discovered, by Fischer Black and Myron Scholes in their 1973 paper “The Pricing of Options and Corporate Liabilities”, there existed no way of pricing options. Thus this mathematical model turned what was essentially a guessing game into a mathematical science which has led to the options market becoming what it is today. Traders will use the Black-Scholes Model to derive a theoretical value for a certain option contract and then compare this value to the prevailing price in order to see if the option is over or under valued. The Black-Scholes formula has been of huge importance in the growth of the options markets and its importance was recognized in 1997 when the Nobel Prize in Economics was given to Myron Scholes and Robert C. Merton (Merton expanded the mathematical understanding of the options pricing model). Fischer Black was mentioned as a contributor but was not eligible for the prize as he had passed away in 1995.

The most common 4 Greeks or Option Greeks are the first order derivatives: Delta,Vega, Theta, Rho and 1 second order derivative, Gamma. These are relatively easy to calculate and a very useful to all derivatives traders who want to hedge their portfolios from adverse changes in market conditions. They enable the trader to measure how much risk is in the portfolio and where this risk lies, therefore, having an intimate knowledge of the Greeks and how they work is a great advantage to all who want to trade options.

Delta : This is the most important and most widely used of the Greeks. It is a measure of the option\’s sensitivity to changes in the price of the of the underlying asset. Delta is always positive for calls (those options that people purchase if people think the stock is going up) and negative for puts (those options people purchase if they think the stock is going to go down). It works in the following way: an option with a delta of 0.5 will move half a cent for every one cent movement in the underlying stock.

Vega : Vega measures sensitivity to volatility (this is a measure for variation of price of a financial instrument over time) of the underlying asset. This means that Vega is typically expressed as the amount of money, per share, the option\’s value will gain or lose as volatility rises or falls. Vega will show the theoretical price change for every 1 percentage point change in the volatility. For example, if the theoretical price is 2.50 and Vega is 0.25, and the volatility moves up 1%, the theoretical price will increase by 0.25 to 2.75. On the other hand if the volatility moves down 1%, the price will decrease by 0.25 to 2.25.

Theta : Theta measures the sensitivity of the value of the derivative to the passage of time, or \’time decay\’. The value of an option consists of two components, intrinsic value (this is the amount of money you would gain if you exercised the option immediately) and time value (this is the worth of having the option of waiting longer when deciding to exercise), also called extrinsic value. As time approaches maturity on an option, there will be less chance of the stock value moving so the time value of an option will be decreasing with time. Therefore, the nearer the expiration date of the option, the higher the Theta value will be and vice versa: the further away the date of expiration, the lower the Theta value. Theta value will indicate how much value a stock option\’s price will decrease per day with all other factors being constant. If a stock option has a Theta value of -0.010, this means that the option will lose 1.00 cent a day, seven days a week. The effect of Theta value does not stop in the weekends.

Rho : Rho will measure the sensitivity of an option to a change in the applicable interest rate. This is the amount of money, per share, that the value of the option will gain or lose as the rate of return of a risk-free investment rises or falls by 1%.

Gamma : The Gamma measures the rate of change in the delta with respect to changes in the underlying price. The Gamma will indicate how the delta of an option will change relative to a 1 point move in the underlying asset. Gamma is the second derivative of the value function (delta being the first) with respect to the underlying price.

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Category: Finances
Keywords: The Greeks, learn to trade, learn stock market,