Question

Question

Delta, Vega, Rho, Gamma and Theta are the five important Greeks which a derivative trader must be aware of. Describe any two out of these five Greeks.

Answer 1

There are different types of risks that need to be considered when taking positions in options. These are commonly known as Greeks based on the names. These Greeks are usually used to hedge risk and to calculate profit and loss as per the movement of prices.

Delta:

Delta is used to indicate the expected amount of change in the price of an option based on the movement in the price of the underlying stock.

This means that if the price of a stock changes, the Delta changes in that direction and the price of the Option will change accordingly. Eg. If the price of a stock goes up by $1 and the call has a delta of $0.50, the price of a call will go down by $0.50.

Calls have a positive Delta between 0 and 1 whereas Puts have a negative Delta between 0 and 1.

Gamma:

Gamma is closely related to Delta in that Gamma gives us the rate of change in Delta based on a $1 movement in the price of a stock.

Therefore, in case Delta can be thought of as speed of change with respect to the price of options, Gamma is the acceleration .

High responsiveness to any change in the price of an underlying stock would yield Gamma with a high value.

The price of near money stocks will almost always be most responsive to changes in the price of the underlying stock. As long as the forecast of the trader is accurate, a high Gamma is an extremely good indicator of change whereas in case the forecast of the trader is inaccurate, a high Gamma can be disastrous.

Theta:

Theta indicates time decay. Theta is most valuable depending on the position of the trader. In case of an option buyer, Theta can be considered as an enemy whereas from the point of view of an option seller, Theta can be considered as a great friend.          

This is because every moment that passes in an options market causes the time value of the option to decrease. At money options have the most erosion in time value when compared to in money or out of money options because at money options have the most time value built into the premium. The more the time value that is included in the price, the higher the loss that can be expected. For out of money option, Theta will be lower as compared to the at money option.

Vega:

Vega is the amount by which the price of the call and put options will change based on a one point change in implied volatility.

Vega only affects the time value of the price of an option and has no effect on the intrinsic value of an option. Therefore, with an increase in Vega, the value of an option also increases as increase in volatility will signify increase in range of movement.

Rho:

Rho is used to identify the change in the amount value of an option based on a one percent change in the rate of interest and is used by more advanced traders.