Options are priced based on their underlying stocks, but the contracts are derivatives and offer no claim of equity like stock ownership does.
The first formula to price options is called the Black-Sholes formula, but today the majority of options on American exchanges are priced using the Binomial Pricing Model.
Option risk can be measured using four different factors, each named after a Greek letter in the alphabet.
- Delta – The primary Greek risk factor is the rate between the option price and the price of the underlying stock. Delta is often used for hedging since it supplies the number of shares needed to offset the option position (ie. delta of 0.6 means 60 shares of stock must be purchased to equal 1 put).
- Gamma – The rate of change between option delta and the underlying stock price. Gamma attempts to measure how much the option delta would move in relation to moves in the stock.
- Theta – All options have an expiration, which means they decay in value as that expiration date nears. Theta measures this time decay factor in relation to the option price.
- Vega – V stands for volatility. Vega measures the option price in relation to the volatility of the underlying asset. An increase in stock volatility won’t always affect an option in the same manner, hence the need for measuring Vega.