Option Greeks are metrics that determine the price of a stock option

The price of a stock option will change over its lifetime depending on various factors known as Greeks.

• Greeks measure the impact that certain factors have on the price of a stock option, namely the price of the underlying option, time decay, and implied volatility.
• While delta is the change in a stock option's price based on the change in the underlying stock's price, it's also used to gauge the likelihood of profitability.
• Greeks demonstrate the challenges of option trading, balancing several factors at once.

When trading stocks, making a profit — as well as minimizing risk — is one of the main things investors pay attention to. But for investors who are a little more advanced, they may want to try options trading, which comes with additional factors such as time decay and implied volatility, which come with complications of their own.

To keep track of these factors, there are something called Greeks. These metrics, represented by various letters in the Greek alphabet, quantify the effect that changes in various factors have on the price of an option. 

Understanding options

Options are contracts that give you the right — but not the obligation — to buy or sell a stock at an agreed price, called a strike price, within a set amount of time regardless of the price of that stock when you exercise the contract. If your strike price is in a favorable position compared to the current stock price, sometimes called a spot price, then you're "in the money" (ITM). If your strike price and spot price are equivalent, you're "at the money" (ATM). If your strike price is in an unfavorable position, you're "out of the money" (OTM).

There are two types of options you can create: calls and puts. A call option allows you to buy the stock at a predetermined price, which means your strike price has to be lower than the spot price to be ITM. A put option lets you sell a stock at a predetermined price to hedge against the market, which means you want the spot price to drop below your strike price.

Though options allow you to buy or sell a stock, options themselves are also treated as a security. In fact, that's their primary use. 

"Most options don't get exercised," says Randy Frederick, managing director of Trading and Derivatives at Schwab's Center for Financial Research. "Believe it or not, only about 10% of all options actually get exercised. Now that doesn't mean that doesn't mean 90% of them expire, it just simply means that only about 10% of the call options that are purchased are actually used to acquire stock."

What are Greeks in option trading?

The value of an option on the market is derived from their potential to acquire stocks at a better price. This value is affected by several factors — the price of the underlying stock, the option's remaining life, and volatility are the most important. This is where Greeks come in. "Greeks are really a way of quantifying the different factors that might affect the price of an option," Frederick says.

The five main option Greeks

There are a myriad of factors that affect the price of an option, but as a retail investor, there are five that you should focus on. 

Delta: The impact of stock prices

Delta measures how much the price of an option will change if the price of its underlying stock changes by a dollar. An option's delta will range between -1.0 to 1.0 — and call options have positive deltas while put options have negative deltas. 

For example, the price of a call option with a 0.5 delta will increase by $0.50 for every $1 that the stock increases. Because put options have an inverse relationship with the price of its underlying stock, a put option with a -0.5 delta would increase in price for every dollar that its underlying stock price drops.

Delta can also be used to indicate the probability that an option will expire ITM, which means that you'll make a profit if you exercise the option. Though an option with a higher delta is more likely to expire ITM, it is also more expensive. 

The delta of an option that's ATM usually sits at a 0.5 value, which means that there's an equal chance that an option will expire ITM or OTM. This is because "if there's nothing going on with any company on any given day, [the stock price] could go up a buck or it could go down a buck. It's about 50-50," Frederick says. 

But the delta usually fluctuates over the course of an option's lifespan, because the probability of an option ending up ITM changes over the course of its lifetime. 

Let's say that the underlying stock price of a call option increases by $1 over the option's strike price. The option is now a dollar in the money, which means it's a dollar further away from being out of the money. For every dollar that the stock price rises, it becomes that much less likely that the stock will drop far enough to fall out of the money. 

The delta of an option also changes based on how far away the option's expiration date is. If a stock is in the money close to its expiration date, chances are that option will stay in the money, which means its delta will increase. Alternatively, if a stock is OTM close to its expiration date, it's unlikely that it will get in the money in that short period of time.

Gamma: The change in delta

Gamma falls into a category known as a second-order derivative Greek, sometimes just called a second-order Greek. Greeks that fall into this category don't measure direct changes to the price of an option. Instead, it measures changes in first-order Greeks. Frederick compares this to the difference between speed and acceleration in high school physics. 

In this case, gamma measures the change in delta, which fluctuates over the course of an option's lifespan. It will range from 0 to 1.0. Gamma is the highest when an option is ATM and when the option approaches its expiration date. 

Gamma can also be thought of as a measure of an option's stability. A high gamma means that the delta is changing frequently, suggesting volatility, which can amplify gains or losses. This can be unappealing for investors looking for something stable.

Theta: The impact of time decay

Options have a limited lifespan — most have a max lifespan of a year. An expiration date limits the amount of time an option has to appreciate. As the option gets closer to expiring, its potential for appreciation decreases, which lowers the option's price. The rate that the price drops as a result of time decay is called theta. 

Theta is measured in a dollar amount that the price of an option drops per day. It's always negative because time only moves in one direction. The rate of decay will start speeding up as the contract's expiration date approaches, at which point the contract expires worthless. 

Vega: The impact of implied volatility 

Vega measures the impact of the implied or expected volatility of the underlying stock on a stock option's price. An option's price benefits from a higher implied volatility because it increases the chance that, at some point, the stock's price will land ITM. "[Vega] tells you how much a 1% change in the expected volatility of this stock impacts the price of an option," Frederick says.

Vega is expressed as a dollar amount per percentage point that the implied volatility moves. If an option has a vega of 0.2 and the implied volatility of the underlying stock rises by 2%, the price of the option would increase by $0.40. An increase in vega will raise the price of both put and call options.

Frederick says that some traders will take advantage of increased implied volatility during earnings season when companies announce their earnings for the year. "If a company says 'Hey, we're going to announce earnings on Thursday of this week,' the options on that particular stock will get very expensive," Frederick says. 

Rho: The impact of interest rates

Rho measures the change in an option's price if interest rates change by 1%. An increase in interest rate will cause call option prices to rise and put option prices to fall. It's calculated similarly to vega as a value that's added or subtracted from the option's price for every 1% change in interest rates. 

Rho is situationally important. They are particularly important in times of high interest rates. They also have a greater impact on long-term stock options (LEAPS), which expire anywhere between one to three years after they're created and during times of high interest rates. 

Minor Greeks

As a novice options trader, there are certain Greeks that are more important to understand than others. Delta is the most important, with its dual function as a rate of price change and a measure of the probability of profit. Theta is a close second, followed by vega. Rho is only applicable in certain scenarios. 

Second derivatives such as gamma are a degree of separation away from the price of an option, which make them a little more complicated to understand and less important. "People who are new to options really don't need to understand gamma, they can just put it away," Frederick says.

While the aforementioned factors are the most important, they're not the only Greeks in the Pantheon. There are various other Greeks that quantify aspects of an option, such as vomma, a second-order derivative that measures the change in vega. Epsilon measures the impact that a change in dividend yields has on stock options.

Part of the reason that options trading can be so difficult, especially for early investors, is because you're taking multiple factors into consideration at the same time. Even if the underlying stock price rises, the option's price might not increase because volatility fell or the stock price rose too late and any profit you've earned has been negated by time decay.