By Ee Hsin Kok. Edited by Arjun Chandrasekar.
When learning about options, you will likely hear about the “Greeks”. The “Greeks” consist of Delta, Gamma, Theta, and Vega. In a previous article, we went over Delta and Gamma, and in this article, we will be going over what Theta and Vega are.
Theta represents the time decay of an option. It tells us how much an option’s price will increase or decrease every day if the underlying asset stays at the same price. For example, if an AMZN call option has a theta of -3.57, it means that if AMZN stays at its current price, the option will lose $3.57 in value over the next day. It is also important to note that theta is not constant, its absolute value will increase the closer an option gets to its expiry date.
You can see the various thetas of AMZN options below (in the first and last columns):
Notice how theta is generally a negative number? This is because when you buy calls or puts, it is like buying insurance, so you pay a premium. And as the option gets closer to expiry, the option begins to cover a shorter time frame, so the premium it can sell for decreases.
Below is a Profit vs Stock Price chart of a call on the SPX. Notice how the purple line (P/L today) is above the green line (P/L at expiry). As you will see below, as days pass, the purple line will move down toward that green line:
3 days later:
Another 3 days later:
There is a way to make Theta work for you though, by selling the option contract instead of buying it, the theta flips. In other words, if you sell one option contract of AMZN with a theta value of -3.57, then you would make $357 over the next day if AMZN stays at the same price.
Theta forms the basis of many price-neutral strategies such as calendar spreads and iron condors. For example, this is the Profit vs Stock Price chart of a calendar spread on the SPX:
On day 1 (Notice how the purple line intersects the current price at the $0 P/L mark):
3 days later (Notice how the purple line has moved up toward the green line):
5 days later (The purple line has risen again):
In the examples above, the underlying asset (SPX) did not have any price movements. Because of that, the calendar spread (which has a positive theta) was able to generate a profit. This example shows you how theta can actually be used to one’s advantage with certain strategies.
Vega represents how sensitive an option’s price is to changes in volatility. It is a measure of how much an option’s price will change in response to a 1% increase in implied volatility. A general rule of thumb is that when you buy options (whether it’d be a put or call), vega is positive. When you sell options, vega is negative. In other words, an increase in implied volatility will be good for those long on options, and bad for those short on options.
You can see the various vegas of AMZN options below (in the first and last columns):
From the image, we can see that the 3470 Call has a vega value of 1.70, meaning that if the implied volatility of AMZN rises by 5%, we can expect the option to go up around 1.70 * 5 = $8.50.
The Greeks: Delta, Gamma, Theta, and Vega are incredibly useful concepts for options traders. Options trading is incredibly flexible, with hundreds of different spread combinations, and if you’re passionate about options trading, you’re likely to explore all these different option combinations and strategies. And if you want to understand all those different strategies, having a good understanding of these terms will be tremendous for your learning.