As you could probably guess, option pricing determines the prices of options. Simple, right? Not so fast…

Option pricing is where the greeks come into play. When you buy a stock, you participate in both upside and downside moves of the stock on a 1-to-1 basis. Options, and out-of-the-money options in particular, allow you to participate in both upside and downside moves on a lot more than a 1-to-1 basis. Options are a bit like stepping from flatland to a world of higher dimensions.

## The Greeks in Option Pricing

** Delta** is the first greek to know in option pricing. It measures the change in the option price for changes in the underlying stock price. An option is said to be at-the-money when the stock is trading near the strike price. At-the-money options tend to trade with a delta of 0.5 meaning that for each $1 move in the stock, the option will move $0.50 all else being equal.

*Delta* ranges from 0 to 1. *Delta* is also known as the hedge ratio or the amount of shares you would need to neutralize the dollar value of price moves. *Delta* can also be thought of as the market’s estimate of the probability that the option will expire in the money. In other words, if an option has a delta of 0.5, the market is assigning a 50% probability to the option finishing in the money. If your research tells you the real probability is 70%, then you can buy the option and have a positive expected value based on your research.

As expiration approaches, *delta* on in-the-money options will approach 1 and *delta* on out-of-the-money options will approach 0. **So deltas change with time.**

** Gamma** is the second greek to know for option pricing.

*Gamma*measures the rate of change in

*delta*for changes in the underlying stock price. As moneyness increases, the stock’s

*delta*increases and that change in

*delta*is

*gamma*.

## The Time Component

The third greek is ** theta** which measures the option’s sensitivity to time. All else being equal, options lose value over time with the fastest declines as expiration approaches.

**Investors often refer to the effects of**

*theta*as time decay.The fourth greek is ** vega** and measures the

**option’s sensitivity to volatility**. With stocks, you always have a

*delta*of 1. With options, you have a view on time and expected volatility as well. You can be right on direction, but if you overpay for

*vega*you can still lose money.

The final greek is ** rho** which measures the sensitivity of an option to interest rates. As rates rise, call option values tend to increase.

## An overview of option pricing greeks:

–*delta* = change in options price for change in underlying asset

–*gamma* = rate of change in *delta*

–*theta* = options sensitivity to time (time decay)

–*vega* = options sensitivity to volatility

–*rho* = options sensitivity to interest rates

In options trading, you frequently need a view on both direction and volatility. At the end of the day, merely understanding the elements of option pricing will put you ahead of other market participants.