Terms Of The Trade: Beta, Delta, Theta

The use of Greek letters in finance typically represents the sensitivity of the price of a derivative, such as an option, to any change in the underlying parameters.

Beta

Beta is a measure of volatility. The beta coefficient of an investment (such as a stock) indicates if the investment is more volatile compared to the general market (such as a major index) or less.

Beta can be calculated using regression analysis and is calculated by dividing the co-variance of the investment's return and the benchmark's returns by the variance of the benchmark's return over a specified time period.

Don't worry about the calculations. Google Finance provides the beta for each stock.

A Beta above 1.0 implies the investment will post returns or losses in excess of the market. For example, if a stock has a Beta of 1.3, it is in theory 30 percent more volatile than the entire market.

Related Link: Terms Of The Trade: 5 Terms To Learn Before You Start Forex Trading

A Beta less than 1.0 implies the investment is less volatile than the overall market while a Beta of exactly 1.0 implies the investment's volatility is consistent with that of the general market.

Beta is a useful tool for investment to analyze the amount of risk a specific investment adds to a portfolio. For instance, if a portfolio of diversified stocks is losing more on a percentage basis compared to the overall market it might be a good idea for investors to remove high beta stocks that have proven to be more volatile.

Delta

Delta is used in finance to measure the rate of change in which an option will decrease or increase in value for every $1 move in the underlying stock.

For example, a Delta of 0.50 implies an option gains $0.50 per contract for every $1.00 move in the underlying stock. When the stock gains $1.00 per share then the option gains $0.50 and when the stock loses $1 per share the option similarly loses $0.50 per contract.

A Delta has to be a number between 0.0 and 1.0 for a long call (or a short put) and between 0.0 and negative 1.0 for a long put (or a short call).

Theta

Theta measures the rate of decline on the time premium in an option.

Before jumping into the details, it is important to recall that options have an expiration date, and the value of an option is essentially composed of its intrinsic value plus the time value.

Suppose a stock is trading at $40 on Thursday and a $50 call option expires on Friday. The option price will likely factor in a near-zero percent chance of the stock soaring to $50 in one single day. On the other hand, a $50 call option that expires in one year will have some value assigned to the time portion since a lot can open over 52 trading weeks.

With that said, Theta essentially measures the risk that time has on the options. Specifically, Theta measures the rate at which an option loses its value as the expiration date approaches.

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