Option Greeks
Factors That Influence
Option Premiums

Option greeks describe the several factors that influence an option’s premium.

Investors who employ options trading strategies must understand the option greeks.

The examples provided below use call options. I used call options intentionally. I think they are easier to understand than put options for investors who are not familiar with options. You can mentally replace the examples with put options. Just remember that put options increase in value when the stock’s price goes down. An in-the-money-put means the stock’s price is BELOW the put’s strike price. An out-of-the-money put means the stock’s price is ABOVE the put’s strike price.

An option’s price can be divided into two components, its intrinsic value and its time value.

• Intrinsic value is the difference between stock price and strike price. It only exists if an option is in-the-money.
• Time value is the amount of an option premium that exceeds its intrinsic value. It accounts for remaining time and is influenced by volatility. I've also seen this referred to as extrinsic value.

An in-the-money option's premium is made up of both intrinsic and time value.

An out-of-the-money option has no intrinsic value and its premium is made up entirely of time value.

Example: MSFT is trading for $24.50 in June. Its JUL 24 call option costs $0.98. This call option has $0.50 of intrinsic value and $0.48 of time value. Its JUL 26 call option costs $0.17 and the entire amount is time value because the call is out-of-the-money.

The factors influencing a call option’s price are identified by Greek letters, known here as the option greeks.

Delta

The first of the option greeks describes how an option's premium is influenced by the underlying stock's price and the price movement.

An option’s premium increases as the stock’s price approaches its strike price. It continues to increase as the option goes farther in-the-money.

The amount an option premium changes for each $1 change in stock price is called its delta.

The option’s delta changes with time and it changes in relation to how close or far away the stock’s price is from the strike price. It’s a complex process and an option’s premium will not increase or decrease by the same amount as the underlying stock price unless the option is deep in-the-money.

Here are some examples of delta values for MSFT trading at about $24.50 in June:

The delta for the JUL 10 call is 1.00 (deep-in-the-money)
The delta for the JUL 22.5 call is 0.87 (in-the-money)
The delta for the JUL 25 call is 0.40 (at-the-money)
The delta for the JUL 30 call is 0.01 (out-of-the-money)

This means that for every $1 change in stock price, the JUL 10 call will change by $1, the JUL 22.5 call will change by $0.87, the JUL 25 call will change by $0.40, and the JUL 30 call will change by $0.01.

I have read that an option's delta is a good approximation for the probability that the option will expire in-the-money. Seems to be a good rule of thumb.

Theta

Another of the option greeks describes how an option's premium is influenced by the time remaining to option expiration.

The option is a “wasting asset” because it loses some of its value with each passing day. The amount of value lost each day is called theta.

Theta increases as the expiration date approaches. In other words, the amount of time value lost each day increases as the expiration date approaches.

Since an out-of-the-money option premium is made up entirely of time value the option will eventually be worth zero at expiration.

An in-the-money option will expire at its intrinsic value with all its time value eroded. You can lose money buying an option even if the stock's price increases and expires in-the-money. This can happen if the price change does not exceed the amount of time value lost.

Here are some examples of Theta values for MSFT trading at about $24.50 in June to show you how theta increases as the expiration date approaches:

Theta for the JUL 25 call is -0.0153 (one month to expiration)
Theta for the OCT 25 call is -0.0076 (four months to expiration)
Theta for the JAN 25 call is -0.0056 (six months to expiration)

This means that the January 2011 25 call is losing 0.0056 each day,the OCT 25 call is losing 0.0076 each day, and the JUL 25 call is losing 0.0153 each day.

Vega

The stock’s volatility has a BIG impact on option premium and is a significant component of the option greeks.

Vega describes changes in volatility. Vega tells you how much the option’s premium changes for each 1% change in volatility. Of all the option greeks it is the least understood.

Investors can look at a stock’s historic volatility, but implied volatility is what influences an option’s premium.

Implied volatility represent's the future expectations for a stock's volatility. Implied volatility is what the traders expect to happen. They could be wrong.

Implied volatility will spike when the stock makes a big move because investors then anticipate more big moves.

Implied volatility will also rise when the company is expected to announce big news. Earnings announcements. Results of test results for bio-tech companies. New product announcements.

Implied volatility will collapse right after the announcement. Any one who bought an option while the implied volatility was high will experience a sudden loss in option value if the stock's price doesn't move a corresponding amount.

An option’s price can change from minute to minute based on implied volatility alone.

Options contracts with longer expiration dates tend to have higher implied volatility. This makes sense because more can happen with a longer time horizon.

A stock can have different volatility based on strike price or expiration date. This is called a volatility skew. Very complicated stuff. There are entire books dedicated to options volatility.

Here are some examples of how vega changes with time for MSFT options:

Vega for the JUL 25 call is 0.0230 (one month to expiration)
Vega for the OCT 25 call is 0.0539 (four months to expiration)
Vega for the JAN 25 call is 0.0733 (six months to expiration)

Here are examples of how a call's premium changes with implied volatility.

AUG 25 call with implied volatility at 21%: $0.59
AUG 25 call with implied volatility at 31%: $0.97
AUG 25 call with implied volatility at 41%: $1.35

Notice how the option's premium jumped by $0.38 (a 40% increase) when volatility rose from 31% to 41%.

It's interesting to consider the impact of time, volatility and simultaneously since that is what happens in the real market.

Let's say that MSFT is trading for $24.50. It's AUG 25 call is trading at $0.97.

Over the next 5 days the stock drops by 5%. Let's assume this results in implied volatility rising from 31% to 50%.

You expect that the AUG 25 call will drop in price because the option is farther out-of-the-money. You also expect the call to be worth less due to time decay. You expect the call to be more expensive due to the increased volatility.

What is the final outcome?

The AUG 25 call's premium rises to $1.08. The effect of implied volatility was greater than the combined effect of time decay and the option being farther out-of-the-money.

Other Factors

There are three additional option greeks to consider but they are minor compared to delta, theta, and vega.

• Interest rate

  The interest rate is the risk-free interest rate that large investors must consider because of carrying costs. The Greek letter that describes premium change due to interest rate is Rho.

• Dividends.

  Dividends affect option premiums because a stock's price goes down when dividends are paid.

• Change in delta.

  Gamma is the Greek letter that tells you how fast delta changes with changes in the stock's price. Don't worry about this.

There are entire books dedicated to option greeks. What I provided is what you need to know to employ options strategies as a dividend investor.

I encourage you to learn more if this stuff options greek stuff interests you.

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