The Four Basic Option Sensitivities
Trading stock options can turn into a fun adventure for many traders who understand the risks and exactly how options operate.
Of course, every investor's experience with these derivatives will be different, with profitable investors enjoying these investments more favorably and unprofitable investors not enjoying them at all.
Probably the most important thing to understand is what drives an option's price.
There are four main sensitivities.
These are what ultimately drive the price of the derivative: 1.
Delta.
The delta is simply the relationship between the derivative's price and the underlying security's price.
A number between 0 and 1, the delta of, say, 0.
95 tells us that for every $1 increase in the price of the underlying security, the option's price will move $0.
95.
It should be known that as the security price changes, the delta will change as well, moving closer to 1 as the price increases for call options and closer to 1 as it decreases for put options.
2.
Theta.
Time is an option's holder's worst enemy.
As time passes, the value of the underlying option will decrease.
Theta tells the investor how much an option's price will change with the passage of each day.
3.
Vega.
Vega tells the options investor who much the value of an option will change given a 1% change in the underlying security's volatility.
While highly specialized, vega is particularly important in periods where a security is trading outside its normal volatility range.
4.
Rho measures how much an option will change in value should the risk-free rate of return change by 1%.
Another specialized sensitivity, this might have come into play during the 2007-2009 credit crisis period.
Ultimately, investors will be most concerned with Delta (the amount of money that an option will increase for every $1 increase in a share price) and Theta (the financial impact that each passing day has on the value of an option).
Options priced "out of the money" (above the stock price for call options, below the stock price for put options) will have lower Delta and greater Theta, meaning that a $1 increase in a stock will not move the option's price all that much, but time will decay its value more.
Comparatively, an option that is priced "in the money" will have a greater delta and a lower theta, meaning every $1 change will have a greater correlation to the option price and time will not decay the value as much.
Options priced "at the money" will fall somewhere in the middle, but keep in mind that "at the money" options typically come with the greatest premiums.
Regardless, understanding the sensitivities and how they impact the performance of a given option will undoubtedly enhance any options investor's personal performance.
Of course, every investor's experience with these derivatives will be different, with profitable investors enjoying these investments more favorably and unprofitable investors not enjoying them at all.
Probably the most important thing to understand is what drives an option's price.
There are four main sensitivities.
These are what ultimately drive the price of the derivative: 1.
Delta.
The delta is simply the relationship between the derivative's price and the underlying security's price.
A number between 0 and 1, the delta of, say, 0.
95 tells us that for every $1 increase in the price of the underlying security, the option's price will move $0.
95.
It should be known that as the security price changes, the delta will change as well, moving closer to 1 as the price increases for call options and closer to 1 as it decreases for put options.
2.
Theta.
Time is an option's holder's worst enemy.
As time passes, the value of the underlying option will decrease.
Theta tells the investor how much an option's price will change with the passage of each day.
3.
Vega.
Vega tells the options investor who much the value of an option will change given a 1% change in the underlying security's volatility.
While highly specialized, vega is particularly important in periods where a security is trading outside its normal volatility range.
4.
Rho measures how much an option will change in value should the risk-free rate of return change by 1%.
Another specialized sensitivity, this might have come into play during the 2007-2009 credit crisis period.
Ultimately, investors will be most concerned with Delta (the amount of money that an option will increase for every $1 increase in a share price) and Theta (the financial impact that each passing day has on the value of an option).
Options priced "out of the money" (above the stock price for call options, below the stock price for put options) will have lower Delta and greater Theta, meaning that a $1 increase in a stock will not move the option's price all that much, but time will decay its value more.
Comparatively, an option that is priced "in the money" will have a greater delta and a lower theta, meaning every $1 change will have a greater correlation to the option price and time will not decay the value as much.
Options priced "at the money" will fall somewhere in the middle, but keep in mind that "at the money" options typically come with the greatest premiums.
Regardless, understanding the sensitivities and how they impact the performance of a given option will undoubtedly enhance any options investor's personal performance.
Source...