Lambda

The answer when someone asks, "What do you want a rack of with mint jelly tonight?"

In options trading, there is a set of measures known as the Greeks. They are called Greeks because they are heavily doused in tzatziki sauce. Er...okay. The category gets its name because each stat is represented by a letter in the Greek alphabet.

Lamda is one of these. It measures the relationship between an option's price and the implied volatility of the underlying asset.

A little quick background: an option offers an investor the right, but not the obligation, to buy or sell some underlying asset, such as a commodity or stock. So you might hold an option to buy 100 shares of JNJ at $150, with the option expiring in July. In that scenario, the shares of JNJ represent the underlying asset. The implied volatility describes the level of expected price fluctuation the market has priced into the shares.

A stock that will rise 5% one day and drop 3% the following day would have a high level of implied volatility. Meanwhile, a $150 stock that doesn't change more than a few pennies on any given trading session would have a low level of implied volatility.

This volatility is key to the options market, since options largely exist as a forward-looking contract. You have the right to buy JNJ at $150 two months from now. How likely the stock is to get to that price point makes a difference.

If shares are trading at $125 now, you need to know the chances they could rise to $150 by the expiration date. That way, you know how much to pay for the option.

Stocks that make big swings have a better chance of moving large distances (price-wise) in a short period of time. A volatile stock might rise from $125 to $150 in a week. A low-volatility stock might need a lot more time to turtle-walk its way there.

Lamda forms the bridge between the option's price and the underlying asset's implied volatility. It measures how much the price of the option changes when the underlying asset experiences a 1% change in implied volatility.