Stock options are a type of financial derivative that give the holder the right, but not the obligation, to buy or sell a specific stock at a predetermined price (called the “strike price”) on or before a specific date (called the “expiration date”). This financial instrument is often used as a way for companies to compensate and incentivize their employees, as well as for investors to speculate on the future movements of a stock’s price.
One of the key aspects of stock options is their use of “greeks,” which are mathematical measures that help to quantify the sensitivity of an option’s value to various factors. The most commonly used greeks are:
- Delta: Delta represents the change in an option’s price for every $1 change in the underlying stock’s price. For example, if an option has a delta of 0.5, then a $1 increase in the stock’s price would cause the option’s price to increase by $0.50.
- Gamma: Gamma represents the change in an option’s delta for every $1 change in the underlying stock’s price. In other words, it measures the rate at which an option’s delta is changing. For example, if an option has a gamma of 0.1, then a $1 increase in the stock’s price would cause the option’s delta to increase by 0.1.
- Theta: Theta represents the change in an option’s price for every day that passes. For example, if an option has a theta of -0.01, then the option’s price will decrease by $0.01 every day.
- Vega: Vega represents the change in an option’s price for every 1% change in the underlying stock’s implied volatility. For example, if an option has a vega of 0.2, then a 1% increase in the stock’s implied volatility would cause the option’s price to increase by $0.20.
To illustrate how these greeks can be used, let’s consider a simple example. Suppose that ABC Inc. is currently trading at $100 per share, and you own a call option with a strike price of $100 and an expiration date in three months. The option has the following greeks:
- Delta: 0.5
- Gamma: 0.1
- Theta: -0.01
- Vega: 0.2
If the stock price increases to $105, the option’s value will increase by $5 (0.5 * $5 = $2.50), and the option’s delta will increase to 0.6 (0.1 * $5 = 0.5). If the stock price decreases to $95, the option’s value will decrease by $5 (0.5 * $5 = $2.50), and the option’s delta will decrease to 0.4 (0.1 * $5 = 0.5).
If one day passes, the option’s value will decrease by $0.01 (-0.01 * $5 = -$0.01). If the implied volatility of the stock increases by 1%, the option’s value will increase by $0.20 (0.2 * 1% * $5 = $0.20).
It’s important to note that these greeks are only approximations, and the actual values may differ due to various factors such as the stock’s dividends, interest rates, and other market conditions. However, understanding the greeks can still be useful for assessing the risks and potential rewards of holding a stock option.
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