30 years: Risk management & derivatives trading

In this video, Lindsey talks about option greeks and explains what each of the option greeks i.e., Delta, Gamma, Theta and Vega indicates

In this video, Lindsey talks about option greeks and explains what each of the option greeks i.e., Delta, Gamma, Theta and Vega indicates

19 mins 2 secs

Overview

Once an option has been bought or sold, the value of the option will move around causing an investment return or a profit or loss for an options trader. The components that could vary altering an options value include the price of the underlying, the volatility of the underlying, and the time to expiry, these are known as the option greeks; Delta, Gamma, Theta and Vega.

Key learning objectives:

Outline each of the option greeks

Understand what each of the greeks indicates

Summary#### What is the Delta of an option?

#### What is the Gamma of an option?

#### What is the Theta of an option?

#### What is the Vega of an option?

The Delta is a measure of how much the value of the option moves when the price of the underlying moves. If the underlying price moves up, the Delta tells you how quickly the value of the option moves with it.

Assume the price of the underlying moves up by $1 and the value of the option increases by $0.25, the Delta is 0.25.

Delta is often used as a proxy for the probability that an option will be exercised, this is due to the fact that in the money options generally have a Delta greater than 50%.

Gamma is the rate of change of an options Delta compared to the underlying asset’s price. Higher Gamma indicates that the Delta could change significantly, even with small price changes in the underlying.

Being long Gamma is a good thing. A call option gives a long Delta position and as the market rises it gets longer. You pay for Gamma when you pay a premium for the option.

Theta is less of a risk measure and more of a measure of exposure to the passage of time. As each day passes, the option loses value. This decay in option values over time is sometimes referred to by options traders as the “rent” that is paid to be long gamma.

If a call option with 3 months to expiration is worth 10.42, and with 2 months to expiration it is worth 7.36, it has dropped 3.06 over the month, or $36.70 per year, which is Theta.

The Vega of an option indicates what happens to the value of an option when the volatility of the underlying changes.

If a 3 month option with 10% volatility was priced at 10.42, and at 11% volatility the price moved up to 12.08, the Vega is 1.67 per vol point.

Lindsey runs Perfordiant, an investment risk and performance consulting firm. He has worked in financial markets since 1992. Lindsey became an MD in fixed income and equities, ran a Risk function, and was on the management team of an Asset Management fintech business. Lindsey is now a Visiting Fellow at the Henley Business School, and resides on the board of CFA UK.

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