Options Premiums are primarily made up of two values. Intrinsic Value and Time Value. Whereas the change in the price of the Option premiums is dependent on five factors called Option Greeks. These are Delta, Gamma, Theta, Vega, and Rho. Know more about options greeks and which Greeks should a trader keep an eye on while trading Options.
Option Greeks are the five pillars, based on which the price of the option is decided. These five Options Greeks include Delta, Gamma, Theta, Vega, and Rho.
Just like a water molecule is made up of 2 elements which are Hydrogen and Oxygen. An Options Premium is made up of these 5 elements. The change in the price of the option premium is decided by these factors unanimously.
Now out of these five Greeks, only three contribute the majority of the working of the option. The rest two Vega and Rho depend on some external factors like the Interest rates and sensitivity to high price swings. Let's learn which Option Greeks are the most important for an Options trader in the immediate next part.
Out of the five Option Greeks that make up the Option premium, a trader should mainly focus on these three Greeks. These include.
Let’s look at how these three affect the price of options and why you, as an Options Trader should know about them.
Delta is the key factor that decides how much should the price of an Option should change. This change is with the respect to the respective underlying, Stock, Index, or commodities. The Delta of an option helps a trader to anticipate the price change and the overall Risk/Reward in a particular strike price. For example, if the Delta of an option is 0.2 then if the underlying moves my 50 points then the option premium will change by 10 points.
In this way, a trader can anticipate the overall move of the options and gain on a trade.
The Second important Options Greeks that you should know is Gamma. Now that you have understood the concept of Delta, Gamma denotes the change of Delta. The delta of an Option keeps on fluctuating as per Gamma. The rate of change in the Delta is denoted as Gamma. For example, if the price of a stock increases by 50 points but the Gamma increases simultaneously, the option price will not increase with the same delta. Which was earlier 0.2. Now the option price will increase by 15 points as the Delta will increase to 0.30. Therefore Gamma is another factor that Options Sellers should keep an eye on as a substantial increase in Gamma can lead to an unusual increase in the Option prices. This might lead to losses for an Option Seller and gain for the buyer of an option.
Now that we know about Delta and Gamma, let's look at the next important Option Greek which is Theta. Theta is like an Ice block that keeps melting with the passage of time. This phenomenon is known as the Theta Decay or time decay. Every Option is made up of two parts. Intrinsic Value and Time Value. The time value is the Theta value of an Option. This keeps on reducing as the expiry of the Option approaches.
The Theta is a friend of an Options Seller and the Enemy of an Options Buyer. As the expiry closes in, the rate of decay increases which leads to more losses to an Option Buyer. Due to this, it is important to choose an Expiry wisely by looking at the Theta Decay for Options Traders.
Options trading is very different from Equity trading where you should just focus on the Underlying. In Options Trading you have to look at the different options greeks and make a view after calculating the Options Greeks. An options trader then has to decide whether to Buy or Sell an Option based on the current market conditions. Hence it is important to know these Greeks before starting options trading.