The Anatomy of Options
Fact checked by SUZANNE KVILHAUG on July 20, 2021
It is important for options traders to understand the complexity that surrounds options. Knowing the anatomy of options allows traders to use sound judgment, and it provides them more choices for executing trades.
The Greeks
An option's value has several elements that go hand-in-hand with the “Greeks":
The price of the underlying security
Expiration time
Implied volatility
The actual strike price
Interest rates
The “Greeks” provide important information regarding risk management, helping to rebalance portfolios to achieve the desired exposure (e.g. delta hedging). Each Greek measures how portfolio's react to minor alterations in a particular underlying factor, allowing individual risks to be examined.
Delta measures the rate of change of an option’s value in relation to changes in the price of the underlying asset.
Gamma measures the rate of change in the delta in relation to changes in the underlying asset’s price.
Lambda, or elasticity, relates to the percentile variation in an option’s value compared with the percentile variation in the underlying asset’s price. This offers a means of calculating leverage, which may also be referred to as gearing.
Theta calculates the sensitivity of the value of the option to the passing of time, a factor known as "time decay."
Vega gauges susceptibility to volatility. Vega is the measure of the option's worth in regard to the volatility of the underlying asset.
Rho appraises reactivity of the option value to the interest rate: it is the measure of the option value with respect to the risk-free interest rate.
Therefore, using the Black Scholes Model (considered the standard model for valuing options), the Greeks are reasonably simple to determine, and are very useful for day traders and derivatives traders. For measuring time, price and volatility, delta, theta, and vega are effective tools.
The value of an option is directly impacted by “time to expiration” and “volatility”, where:
The price of the underlying security has a differing effect on the value of call options as compared to put options. 
An Options Premium
This occurs when a trader purchases an options contract and pays an upfront amount to the seller of the options contract. This options premium will vary, depending on when it was calculated and which options market it is purchased in. The premium may even differ within the same market, based on the following criteria:
Call and put options do not have matching values when they reach their mutual ITM, ATM, and OTM strike prices due to direct and opposing effects where they swing between irregular distribution curves (example below), thereby becoming uneven.
Image by Julie Bang © Investopedia 2020
Strikes are the number of strikes and increments between strikes are decided by the exchange on which the product is traded.
Options Pricing Models 
When using historical volatility and implied volatility for trading purposes, it is important to note the differences that they imply:
Historical volatility calculates the rate at which the underlying asset has been experiencing movement for a specific period of time—where the yearly standard deviation of price changes is given as a percentage. It measures the degree of volatility of the underlying asset for a specified number of previous trading days (modifiable period), preceding each calculation date in the information series, for the selected time frame.
Implied volatility is the combined future estimate of the volume of trading of the underlying asset, providing a gauge of how the asset’s daily standard deviation can be expected to vary between the time of calculation and the option's expiration date. When analyzing an option's value, implied volatility is one of the key factors for a day trader to consider. In calculating an implied volatility, an options pricing model is used, taking into account the cost of an option’s premium.
There are three frequently used Theoretical Pricing Models that day traders can utilize to help compute implied volatility. These models are the Black-Scholes, Bjerksund-Stensland, and Binomial models. The calculation is done with the use of algorithms—usually using at-the-money or nearest-the-money call and put options.
The Black–Scholes model is most commonly used for European-style options (these options may only be exercised at the date of expiration).
The Bjerksund–Stensland model is effectively applied to American-style options, which may be exercised at any time between purchase of the contract and the date of expiration. 
The Binomial model is appropriately used for American-style, European-style, and Bermudan-style options. Bermudan is somewhat of a midway style between a European- and American-style option. The Bermudan option may be exercised only on specific days during the contract or at the expiration date.
Related Articles
Using the "Greeks" to Understand Options
The Importance of Time Value in Options Trading
Understanding How Options Are Priced
Understanding Warrants and Call Options
Taking Advantage of Volatility Spikes with Credit Spreads
Option Greeks: The 4 Factors to Measure Risk
Related Terms
What Is the Black-Scholes Model?
The Black-Scholes model is a mathematical equation used for pricing options contracts and other derivatives, using time and other variables. more
How Implied Volatility (IV) Helps You to Buy Low and Sell High
Implied volatility (IV) is the market's forecast of a likely movement in a security's price. It is often used to determine trading strategies and to set prices for option contracts. more
What Is a Lattice-Based Model?
A lattice-based model is a model used to value derivatives; it uses a binomial tree to show different paths the price of the underlying asset may take. more
Greeks Definition
The "Greeks" is a general term used to describe the different variables used for assessing risk in the options market. more
Strike Price Definition
Strike price is the price at which a derivative contract can be bought or sold (exercised). more
Vanilla Option Definition
A vanilla option gives the holder the right to buy or sell an underlying asset at a predetermined price within a given time frame. more
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