What are Options Greeks (and Why Should I Care)?

We are often told that option Greeks are very complex, and in fact this complexity is one of the reasons that many business and traders fear options or steer clear of them altogether. However, the option Greeks exist for one very simple purpose: they convert the vague and chaotic nature of option pricing into orderly specifics that enable you to make decisions.

You can trade options without understanding the greeks, and in fact, you can even be quite good at it.  However, this is like driving a car without a dashboard. You can tell how fast you are going, what your RPMs are, how much guess you have left and what gear you are in by feel and memory, but you are making things a lot harder on yourself rather than just learning how to read the dashboard.

So what are option greeks?

Much like how the instruments on a dashboard provide specifics on the internal process of the cars engine, Option greeks convert the internal processes of the option price into specifics.

There are five primary Option Greeks: Delta, Gamma, Theta, Vega and Rho. But before I tell you what these are for, lets present you with the problem that options Greeks help to solve.

Imagine you and a friend are bullish coffee. Your friend buys a future and you bought a call.

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Scenario 1:

The coffee futures rally 10c. Your friend makes 10c on his 1 future, but you only make 5c on your call. Why is that?

Scenario 2:

The coffee futures don’t move much and the market closes unchanged. Your friend makes 0c on his 1 future, but you lose 1c on your call. What the heck?

Scenario 3:

The coffee futures have an extraordinary day, rallying 20c on a frost rumor, but than collapsing back to unchanged when the rumor dissolves and again the market closes unchanged. Your friend makes 0c on his 1 future, yet you make 2c on your call. Huh?

If you do not understand how option Greeks work, these scenarios may seem perplexing to you, but if you do, then they make perfect sense and moreover, you would have anticipated these outcomes.

The little-known secret about option Greeks, is that the Greeks actually make options simpler and easier to understand rather than harder and more complex. 

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The complex part is the math behind calculating the greeks, this is truly advanced math, but not difficult to understand if you have some college-level advanced calculus under your belt. The good news is that you don’t need to understand the math that creates the Greeks, much like you don’t need to understand Newtonian physics to drive a car. You just need to understand how to use the outputs.

So let’s talk briefly about 3 of the 5 option Greeks and how they could have been used in the scenario above.

Delta – this is the simplest and most useful of the option Greeks. It tells you how many equivalent futures an option is. For example, an option with a 0.5 delta behaves as if it were 50% of a future. So in scenario 1 above, our call had a 50% delta which means when the future rallied 10c, the option gained 5c in value.

This lets our trader predict how the option value will change based on the price movement of the underlying. If the market fell by 4c, the trader knows that our option with 50% delta would only lose 2c.

Theta – Theta is one of the easiest Greeks to understand. An option has a time limit at which point it either has value or it is worth nothing. When the trader buys the option, a large portion of the price is the time value, i.e. a premium paid for every day the option will be live. Theta tells you how much value an option will lose per day.

In scenario 2, even though the price did not change the option still lost money because some of the time value was consumed.

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Vega – Options are particularly valuable in volatile price environments because of their asymmetrical payoff structure.  In other words, owning options has a high profit potential and a relatively low loss potential, so in times of volatility and uncertainty they become more valuable. Vega tells you how much the option will increase in value based on an increase in vulnerability.

In scenario 3, the volatility became higher, even though the underlying price didn’t change and therefore the option increased in value. A savvy trader knows that buying options means an exposure to volatility, so they will often buy options when they think volatility will increase even if they are unsure of the direction.

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Conclusion

Notice what I didn’t do in this article, we didn’t talk about any of the math involved in calculating the Greeks. However, what we did see is how useful the Greeks can be in understanding how an option will behave in a variety of different circumstances. The core value of an option is the very fact that it behaves differently from a future. Option Greeks help us to understand how it behaves differently, and in what ways.

Right now, we have just scratched the surface of how options are used and understood, but don't worry! We can help you take the next steps.

 If you're interested in learning how options are priced, how to build practical hedging strategies, and how professionals use options to manage risk, we cover all of that in our next Coffee Options Course (July 22–24). Whether you're new to options or looking to strengthen an existing hedging program, you'll leave with practical tools and frameworks you can apply immediately. Register today!