Delta, Vega and other Greeks

Financial derivatives can be volatile and sensitive to factors such as changes in the pricing and volatility of the underlying asset.

Delta and Vega are two of the 5 Greeks (measurement tools) that can give us an idea of

Delta

Delta measures option price sensitivity to changes in the price of the underlying asset.

Option Delta is perhaps one of the most vital measurement methods of all, as it can investigate the level of sensitivity that an option’s price will move, if there is a change in the underlying currency pair.

(As with all the other options greeks, we assume that all other of the options parameters don;t change hen looking at delta).

If the option has a delta of 1.5, it means that there will be a price movement of 1.5 cents for every cent the underlying currency pair moves.

Therefore, this shows that an option with a high delta reading will increase or decrease in value more considering the direction of the price change.

As compared to another option with a low delta which will not move as much from changes in the price of the underlying asset.

How is It Used?

The importance of the information that the Greek Delta can provide is indispensable. This is especially the case where, in the real world, investors rarely hold options until maturity.

Knowing how much profit that can be reaped or the potential losses that will be incurred from a single movement in price will decide for the investor whether they should still hold the option or choose to sell it.

Complication

Unfortunately there is a complication with delta: it also moves as the price moves. So that 1.5 delta option may move 1.5 cents higher for 1 cent move in the underlying, but then the delta may have changed to 1.6.

Hence any further increase in share price will cause an even bigger increase in the price of an option. This affect is an example of positive gamma – to be explained in our next lesson – and can be thought of as the price ‘accelerating’ higher.

What is Vega?

Volatility is a measurement of the amount and speed with which price moves up and down and is frequently based on changes in the (recent) highest and lowest historical prices in a trading instrument, such as a currency pair.

Vega, the only Greek that is not represented by a Greek letter, measures an option's sensitivity to changes in the volatility of the underlying asset. Vega represents the amount that an option's price changes in response to a 1% change in volatility of the underlying market. The more time that there is until expiration, the more impact increased volatility will have on the option's price.

Because increased volatility implies that the underlying instrument is more likely to experience extreme values, a rise in volatility will correspondingly increase the value of an option, and, conversely, a decrease in volatility will negatively affect the value of the option.

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Theta: Sensitivity to Time Decay

Theta measures the time decay of an option, the theoretical dollar amount that an option loses every day as time passes, assuming there are no changes in either the price or volatility of the underlying.

Theta increases when options are at-the-money and decreases when options are in- and out-of-the-money. Long calls and long puts will usually have negative Theta; short calls and short puts will have positive Theta. By comparison, an instrument whose value is not eroded by time—such as a stock—would have zero theta.

The value of an option can be expressed as its intrinsic value and time value. The intrinsic value represents the dollar value gained if the option were exercised immediately: it is the difference between the strike price of the option and the actual underlying's price. An option's time value, on the other hand, is a function of the time remaining until expiration and how close the option's strike price is to underlying's price. The time decay that theta represents is not constant; the rate increases as expiration nears.

Using the Greeks in Forex Options Strategies

Similarly to stock options, forex options can be used to either make money or reduce risk in existing positions. Options provide a means to enter the foreign exchange market with limited risk, as losses are typically limited to the amount of money that is paid for the premium. The upside potential can be far greater than any loss of premium, making for favorable risk/reward ratio.

Forex options are also used to hedge against existing foreign exchange positions. Because forex options give the holder the right-but not the obligation-to buy or sell the currency pair at a specific exchange rate and time in the future, they can be employed to protect against potential losses in existing positions.

Whether a trader is long or short a foreign currency pair, forex options can be used to protect the trader from risk, while giving the existing position room to move without getting stopped out.

The Bottom Line

The Greeks are an important tool for all options traders and can be helpful in identifying and avoiding risk in individual options positions or in options portfolios. The Greeks can be applied in complex strategies involving mathematical modeling, generally using software that is available through trading platforms or proprietary vendors.

Alternatively, forex options traders may use just one or two of the Greeks to confirm investing decisions.

Because of their complexity, the Greeks demand patience and practice in order to fully realize their potential as part of an overall options strategy. Using the Greeks for any type of options analysis can help traders determine an option's sensitivity to price and volatility changes, and to the passage of time.

What is Gamma?

What is it?

We saw above that the Greeks are an important measure of risk to used by options traders to assess the impact in changes of certain variables on the price of an option.

In particular we looked at one of these, delta: the sensitivity of option prices to changes in the price of the underlying security.

Unfortunately, again as we saw, the relationship between the underlying asset's price sensitivity (delta) and the price is not linear.

For example if a currency pair moves up, call options will become even more sensitive to further changes to the currency pair's price. This effect is called gamma. It measures the change in delta, i.e. sensitivity to the underlying asset's price movements.

Positive gamma means that as a currency pair rises the option’s price will more sensitive to further currency pair price changes. Negative gamma means the opposite: the currency pair price rises cause the underlying pair to be less sensitive.

Why should we be concerned about Gamma?

Gamma is the key enemy of many of the options strategies we use. It tends to rise as an option moves closer to expiration. Hence in the last week of an option’s life small changes in the underlying's prices cause large, and accelerating, swings on options prices.

This is unfortunate as many of favourite strategies rely on time decay – i.e. relay on time passing to make money.

Often a trader has to weigh up the potential profits, from time decay, of leaving a strategy on versus the increasing risk of the currency price moving and wiping out those profits.

It is for this reason that most experienced options traders rarely keep a trade on until expiration. They would get out of the trade within 2 weeks of expiration to avoid the gamma risk.

Indeed such is the power of gamma that trading with positions with large gamma – expiration week trades for example – is known colloquially as ‘riding the gamma bull’. Not for the faint hearted.

Uses of Gamma

We’ve seen that Gamma is often seen as an enemy. But this is usually only relevant to those trades, admittedly the most popular, that relay on time decay to profit.

Some trades, however, take the opposite course: they take advantage of the accelerating price sensitivity from gamma to make money from expected changes in the underlying's prices.

One good example of this is the straddle, the simultaneous purchase of an at-the-money put and call.

Let’s say EURUSD is at 1.1300. We expect significant price movement, after the release of US non-farm employment report, over the short term and so buy a 1.1300 strike call and a 1.1300 put.

Such a purchase has strong gamma: currency movement not only increases the price of the spread, these price changes are increased the more the currency price changes, either way.

The catch, and key risk, is the opposite of the trades mentioned above: time.

Time decay works against us here: if there is no currency underlying movement then the spread will gradually lose money. Indeed the spread loses value every day all things being equal and so there is an amount of the underlying price movement required each day just to break even.

The trader has to be sure that the currency pair moves, and moves quickly, for the trade to be profitable.