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Greeks in Trading: what are they and what types are there?
One of the terms in trading is Greeks, which go hand in hand with the risks that each person may have at the time of making a negotiation. Here we will tell you what they are and the types there are.
What are the Greeks?
In the trading world, the different Greek letters are used to describe and measure the different risk parameters when taking a position. Each of these letters represents a specific type of risk, related to the interaction between the option and some other market variable.
Traders rely on these Greek values to evaluate and understand the risks associated with their positions, and thus manage those risks more effectively. Thanks to Greeks, investors can make better informed decisions by considering the key risk factors that can affect the value of an option.
Some of the main “Greeks” are delta, gamma, rho, theta and vega. Each of these elements has a value associated with it, which allows traders to understand the risk associated with the option or how it behaves.
It is very important to note that these values are not fixed and are subject to change over time. Therefore, traders can periodically calculate these figures to determine if market variations have affected their portfolio to the point of needing rebalancing.
For that reason, it is important to take into account other methods of technical and risk analysis to make a more informed decision, such as the MACD indicator or the RSI indicator.
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What are the most important Greeks you should know?
As mentioned above, the Greeks are based on the letters of the Greek alphabet and are used to measure risks. Some of the most important ones are:
Delta
Delta is the first of the Greek letters used in the market, and represents the rate of change between the option price and a $1 change in the price of the underlying asset. This metric explains the sensitivity of the option price in relation to its underlying asset.
In the case of a call option, the delta ranges from zero to one, while a put option has a delta ranging from zero to minus one.
Delta works as follows: if a call option has a Delta of 0.6, this means that a $1 change in the price of the underlying asset would translate into a $0.60 increase in the price of the option..
There is a strategy in which traders establish a delta-neutral position and, as expected, the delta of this position represents the hedge ratio of the position. For example, if you were to buy a call option with a delta of 0.6, you would need to sell 60 shares of the stock at the same time to be fully hedged on this position. In addition, it is possible to use the net delta of an entire portfolio of options to determine the hedge ratio of the entire portfolio.
The delta can also be used to estimate the probability that an option will close in-the-money. For example, a call option with a delta of 0.6 is said to have a 60% probability of ending in-the-money.
Gamma
Gamma is the rate of change between the delta of an option and the price of the underlying asset. While delta represents first-order price sensitivity, gamma is considered a measure of second-order sensitivity. It quantifies the expected change in delta for every $1 change in the underlying asset price.
For example, if a trader buys a call option with a delta of 0.6 and a gamma of 0.1, it is assumed that for every $1 change in the value of the underlying asset, the delta of the call option will increase or decrease by $0.1.
Gamma is useful for assessing the stability of an option's delta. The higher the gamma, the more likely it is that the delta will change significantly in response to small changes in the price of the underlying asset. Gamma increases as options move closer to the money. It also intensifies as the expiration date approaches. Consequently, gamma values are typically low for options that are far from expiration, but increase as the expiration date approaches.
Option traders may choose to hedge gamma and delta, thus creating a delta-gamma neutral position. In this configuration, the option's delta remains close to zero, regardless of movements in the price of the underlying asset.
Rho
Rho is a measure of the rate of change of an option price in response to a 1% change in interest rates. This metric shows us the sensitivity of the option to interest rates.
For example, considering a call option with an rho of 0.1 and a current price of $1.40, if interest rates rise by 1%, the option price could rise to $1.50, holding all else constant. Put options, on the other hand, tend to appreciate in value when interest rates fall, especially those that are at-the-money and have a long term to expiration.
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Theta
Theta is a representation of the rate of change between option price and time, also known as time sensitivity or time decay. Theta indicates how much the price of an option will decrease as expiration approaches, holding all else constant.
For example, if a trader has a long position in an option with a theta of 0.6, the option price is expected to decrease by $0.60 per day, holding all other variables constant.
When an option is closer to being in-the-money, the theta approaches zero. Long call and put options have negative theta, while short call and put options have positive theta. In addition, the time decay of options accelerates as expiration approaches. In comparison, an asset that does not suffer price erosion due to time will always have a theta equal to zero.
Vega
Vega is a measure of the sensitivity of an option's value to the implied volatility of the underlying asset. This metric indicates how much the price of an option will vary with a 1% change in the volatility of the underlying asset.
For example, if an option has a vega of 0.2, this means that the option price will vary by $0.20 for every 1% change in the volatility of the underlying asset.
Increasing the volatility of the underlying asset not only influences the price sensitivity of the option, but also increases the probability that the asset will reach extreme values. This, in turn, increases the value of the option associated with that underlying asset.
On the other hand, a reduction in volatility has a negative impact on the option price. Vega tends to be higher for options that are in the money and have a long time to expiration.
It is interesting to note that there is actually no Greek letter called vega. Various theories explain how this term was incorporated into the group of Greek letters that represent the risks associated with options.
