The Greeks series'¦

The posting on December 28th titled "Where Do Option Prices Come From?" touches on pricing models and discusses implied volatility. The next level is to discuss some of the data a pricing model provides besides the premium; this data is referred to as the Greeks.

In the real world all of the variables move at once. The Greeks isolate each of these variables in turn, providing insight on how the option premium will be affected if that variable changes. Many option traders make the mistake of only thinking that the underlying price movement adjusts the option price, when it is very possible for the underlying to stay at the same price and see the option contract go up or down in value. 

I believe if you have a firm understanding of these variables, you'll know what option is the best to trade, based on your outlook for the underlying. If you don't contend with the Greeks, though, you could be flying blind.

My next series of blogs will address all the Greeks, their importance, and how to interpret and use each of them in your trading decisions. The following are the definitions of each Greek. 

Delta: The amount a theoretical option's price will change for a corresponding one-unit (point) change in the price of the underlying security.

Gamma: The amount a theoretical option's delta will change for a corresponding one-unit (point) change in the price of the underlying security. 

Theta: The amount a theoretical option's price will change for a corresponding one-unit (day) change in the days to expiration of the option contract.

Vega: The amount a theoretical option's price will change for a corresponding one-unit (point) change in the implied volatility of the option contract. 

Rho: The amount a theoretical option's price will change for a corresponding one-unit (percent) change in the interest rate used to price the option contract.

Regards,
Brian (OG)

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.

The Greeks represent the consensus of the marketplace as to the how the option will react to changes in certain variables associated with the pricing of an option contract. There is no guarantee that these forecasts will be correct.