In finance, Greeks measure the sensitivity of the option prices to a change in underlying parameters which are price of the asset, interest rate, volatility and time decay.
The name “Greeks” is used because they are denoted by Greek letters. Greeks are vital tools in risk management and trading options without the knowledge of Greeks can result in heavy losses. The most common of the Greeks are Delta, Vega, Theta, Rho and Lambda. We will be discussing about these Greeks in detail.
Delta: It measures the rate of change of option value with respect to change in the underlying asset’s price. Suppose you buy a call option for a stock A which is trading at Rs 1,000. Now delta will be a value which will be between 0 and 1 for a long call or short put and it will be between 0 and -1 for long put or short call. So if a delta of a call is .5 then it means that if the price of the underlying increases by Rs 1 then the value of the option price will increase by 50 paise. Similarly if the delta of a contract is -0.5 then the value of the option will decrease by 50 paise for a Rs 1 increase in the underlying.
Delta is close to zero for out-the-money options and close to 1 or -1 (depending on the type of option) for at-the-money and in-the-money options.
Vega: Vega estimates the change in the value of the option when implied volatility (IV) changes by 1 per cent. Change in IV will affect both call and put options in the same way; increase in IV will increase an option’s price and decrease in IV will decrease the option’s price.
The reason for this is that higher fluctuations in the price of the underlying will result in a greater possibility of the option moving in the buyers favour.
The impact of IV is greater for at-the-money options than for the in-the-money and out-the-money options.
Theta: It estimates the rate of change of the value of the options with respect to the passage of time with all else remaining the same. Long calls and long puts always have negative theta while short calls and short puts have positive theta. Theta does not reduce the value of the option at an even rate. It has much more impact on an option that is nearing expiration than an option that is still far away from expiration.
Rho: It estimates the change in the value of the option when risk free interest rate changes by 1 per cent. Except under extreme circumstances value of an option is less sensitive to changes in the risk free rate than to changes in other parameters.
Lambda: It is percentage change in option value divided by the percentage change in the underlying price. It is a measure of leverage and sometimes called gearing.