Don’t Forget the Greeks

You can't consider yourself "stock option literate" if you don't know the Greeks. Option traders analyze underlying stock and hope to leverage that knowledge through use of the surrogate stock option. But a stock option doesn't necessarily mirror the movements of the underlying stock. The Greeks can help a stock option trader to understand the vital relationship between a stock and its derivative. To pursue that most popular of Greeks-Alpha (profit) - you need the other Greeks to help smoke it out.

1. Beta: is a measure of correlation between the general market and an individual stock. For example if the stock market index moves up 1%, a stock which also moves up 1% would have a beta of 1.0. A stock which moves up .5% would have a beta of .50. A stock that moves in a direction opposite to the market would have a negative beta.
2. Delta: is of particular interest to stock option traders. The Delta is a measure of the correlation between option premium price movement and that of its underlying stock price. For a call option, if an option premium goes up $.50 for a corresponding move of $1 for the underlying stock, the option would have a Delta of .50. For a put option contract, the Delta is the relationship of a rise in put option premium as the underlying stock prices fall.

An important fact to understand is that as an option approaches expiration, the time value of an option approaches zero and the Delta between option premium and underlying stock goes to 1.0.

1. Gamma: measures the correlation of delta as it approaches an in-the- money status. For example, a Gamma change of 0.50 indicates the price of the option premium rate of movement will increase by 50% if the underlying price approaches the strike price. When an option is way out or the money, Gamma is very low and increases as it approaches the strike price.
2. Lambda: measures the leverage an option has in relation to the underlying stock. For example, if the underlying stock price changes 1%, an option with a high Lambda would change more than 1%.
3. Rohm: is a measure of correlation of option value to change in interest rates. Rohm indicates the absolute change in option value for a one percent change in the interest rate. For example, a Rohm of .060 indicates the option's theoretical value will increase by .060 if the interest rate is decreased by 1.0.
4. Theta: is a measure of correlation of option value to time decay. Theta indicates a change in the option value for a 'one unit' ( 7day) reduction in time to expiration For example, a theta of -250 indicates the option's theoretical value will change by -.250 if the days to expiration is reduced by 7.
5. Vega: is a measure of correlation of option value to change in volatility. For example, a Vega of .010 indicates an absolute change in the option's theoretical value will increase by .010 if the volatility percentage is increased by 1.0 or decreased by .090 if the volatility percentage is decreased by 1.0. (Volatility is a measure of price variation from a mean price over a period of time. High volatility means large and frequent price swings.)