Option Greeks and Management of Market Risk

In mathematical finance, the Greeks are the quantities representing the sensitivity of the price of derivatives to a change in underlying parameters on which the value of an instrument or portfolio of financial instruments is dependent. The name is used because the most common of these sensitivities are often denoted by Greek letters Collectively these have also been called the risk sensitivities, risk measures or hedge parameters.

 Trading options without an understanding of the Greeks - the essential risk measures and profit/loss guideposts in options strategies - is synonymous to flying a plane without the ability to read instruments. Many traders are not option strategy "instrument rated"; that is, they do not know how to read the Greeks when trading. This puts them at risk of a fatal error

 When taking an option position or setting up an options strategy, there will be risk and potential reward from the following areas:
Price change Changes in volatility Time value decay Interest rate changes

Parameters of SENSITIVITY Delta = Theta = Vega = Rho =

 The Greeks as they are commonly known are simply shorthand references to the partial derivatives of the BlackScholes equations with respect to its various parameters. There are five basic Greeks that are commonly used: Delta () measures how much the option price will change when the underlyings price change. Vega () measures the change in the option price when volatility changes. Theta () measures the change in the option price as time changes. Rho () measures the change in the option price as the interest rate changes.

 Delta, measures the rate of change of option value with respect to changes in the underlying asset's price. Delta is the first derivative of the value V of the option with respect to the underlying instrument's price S.

For a Call: (c) = c/S = N(d1) For a Put: (p) = p/S = N(d1) -1

 Calls have positive delta, between 0 and 1. That means if the stock price goes up and no other pricing variables change, the price for the call will go up. For example. If a call has a delta of .50 and the stock goes up $1, in theory, the price of the call will go up about $.50. If the stock goes down $1, in theory, the price of the call will go down about $.50. Puts have a negative delta, between 0 and -1. That means if the stock goes up and no other pricing variables change, the price of the option will go down. For example, if a put has a delta of -.50 and the stock goes up $1, in theory, the price of the put will go down $.50. If the stock goes down $1, in theory, the price of the put will go up $.50.

 Vega measures sensitivity to volatility. Vega is the derivative of the option value with respect to the volatility of the underlying asset
For Call Option (c) = c/ For Put Option (p) = p/
Vega is typically expressed as the amount of money per underlying share that the option's value will gain or lose as volatility rises or falls by 1%.

 Time decay, or theta, is enemy number one for the option buyer. On the other hand, its usually the option sellers best friend. Theta is the amount the price of calls and puts will decrease (at least in theory) for a one-day change in the time to expiration. Theta, measures the sensitivity of the value of the derivative to the passage of time, the "time decay."

 In the options market, the passage of time is similar to the effect of the hot summer sun on a block of ice. Each moment that passes causes some of the options time value to melt away. Furthermore, not only does the time value melt away, it does so at an accelerated rate as expiration approaches.

 Rho, measures sensitivity to the interest rate It is the derivative of the option value with respect to the risk free interest rate Except under extreme circumstances, the value of an option is less sensitive to changes in the risk free interest rate than to changes in other parameters. For this reason, rho is the least used of the first-order Greeks. Rho is typically expressed as the amount of money, per share of the underlying, that the value of the option will gain or lose as the risk free interest rate rises or falls by 1.0% per annum (100 basis points)

 When interest rates rise, call prices will rise and put prices will fall. Just the reverse occurs when interest rates fall. Rho is a risk measure that tells strategists by how much call and put prices change as a result of the rise or fall in interest rates. The Rho values for in-the-money options will be largest due to arbitrage activity with such options.