A slew
of factors influences an options contract’s price. These factors can either
hurt or help traders depending upon the kind of positions they choose to take.
Successful and seasoned traders are aware of the factors that affect options
pricing. These factors include the popular ‘greeks:’ a set of four risk
measures named after Greek letters. Each of the letters individually affects
how sensitive a particular options contract is to changes in implied
volatility, time-value decay, and movement in the price of the security. These
measures are therefore referred to as ‘vega,’ ‘theta,’ gamma,’ and ‘delta.’
Understanding
Options Contracts
Before
we dive into understanding options greeks, let’s address what the purpose
of options contracts is, to begin with. The goal is to hedge a portfolio and
offset any potentially unfavorable moves seen in other investments. One can
also rely on options
contracts to speculate on whether an asset’s price may rise or
fall. In short, using a put option allows a holder to sell the underlying
security at a predetermined price at some point in the future. Alternatively, a
call option allows the trader to purchase a certain security at a predetermined
price at some point in the future.
Options can
be used such that they are converted into shares of
the underlying asset at the predetermined price on the contract which is known
as the strike price. Each options contract has an ending date known as its
expiration date as well as a cost or value that is associated with its purchase
known as its premium. The price of the option — its premium — is typically
based on the options pricing model, like that by Black-Scholes, which
eventually causes fluctuations in its premium. The four options
greeks are often viewed in conjunction with the option’s price model so
one can understand and gauge any associated risks.
Option
Greeks Meaning
Now
that we know the answer to what is an options greek, breaking down what each of
the four options greeks signify is vital.
This blog will explore the key Option Greeks: Delta, Gamma,
Theta, Vega and Rho. These factors affect the price of an option and therefore,
if you are an option trader or aspiring to become one, a deep understanding of
these is essential to successfully apply them.
Option Greeks Factors
1. Delta
The first Greek is Delta, which quantifies how
much an option's price is projected to fluctuate for every ₹1
that the underlying securities or index changes in price. A Delta of 0.50, for
example, indicates that the option's price will fluctuate ₹0.50
for every ₹1 movement in the price of the underlying stock or index.
Call options have a positive Delta since the
value of a call option increases with an increase in the price of the
underlying asset. Similarly put options have a negative Delta since the value
of a put option decreases with an increase in the price of the underlying asset
and vice-versa.
The value of Delta oscillates between 0 and 1
for a call option and between -1 to 0 for a put option. The value of Delta for
an At-The-Money (ATM) option is usually close to 0.5 for a call option and -0.5
for a put option.
Now, the value of Delta approaches 1 or -1 as
the moniness of the call or put option increases respectively. Deep in the
money call options have a Delta close to 1 and deep in the money put options
close to -1 since the price of a deep in the money option seeks to behave almost
exactly as the underlying asset. Similarly, out of the money options have Delta
close to 0 since there is a very high probability of such options to expire
worthless.
As we get closer to expiry, the Delta of options
tends to 0 because the time remaining for any significant move in the
underlying asset tends to 0.
2. Gamma
Assuming the underlying asset to be
displacement, delta is speed and gamma is acceleration. The first derivative of
the underlying asset (w.r.t. time) gives us delta and the second derivative of
the underlying asset (w.r.t. time) gives us gamma or the first derivative of
delta (w.r.t. time) gives us gamma.
Delta is only accurate at a specific price and
at a specific moment. The Delta in the previous example is no longer 0.50 once
the stock has moved ₹1 and the option has moved ₹0.50. As previously indicated, a ₹1
move would push a call option farther into the money, bringing the Delta closer
to 1.00.
Assume that the Delta is now 0.6. This is a 0.1
increase in Delta from 0.50 to 0.60. In this case, the options gamma would be
0.1. Now, if the stock moves further more into the money, the delta will tend
to 1 but at a decreasing rate, so essentially the gamma would decrease slowly
so as to make the delta tend to 1 but not exceed 1.
3. Theta
Theta is the option buyer’s biggest enemy and an
option seller’s best friend. Theta is a measure of the time decay prevalent in
options. The time component is as important as the price of the underlying
asset as a factor in the determination of an option’s fair value.
Theta is not linear in nature, it increases
significantly as the option approaches expiry. Intuitively, it can be seen that
as the time to expiry decreases, the time available for the underlying asset to
make any sort of big moves decreases, this increases theta and the price of the
option decreases. This is one of the primary reasons that most of the options
end up expiring worthless and most of the option buyers end up losing their
money.
4. Vega
Apart from the price movement of the underlying
asset and time, volatility is an extremely important factor that influences the
price of an option. Vega takes into consideration this measure and even though
it is not an actual greek letter, it is an important and widely-used greek in
option trading.
The rate of change in an option's price per 1%
change in the implied volatility of the underlying stock is measured by Vega.
Since, an increase in volatility enables the underlying asset to make wide
swings, this is factored into the price of an option through Vega.
A decrease in Vega causes both call and put
options to lose value, while a rise in Vega causes both call and put options to
gain value.
Generally speaking, it is a good idea to buy
options when Vega is below the normal levels and it is a good idea to sell
options when Vega is above the normal levels. This is because any contrary
change in Vega will cause the respective party good gains. This is essentially
a contrarian strategy in its most basic form and is generally used along with a
variety of other tools.
Final Note
This blog discussed the Option Greeks- Delta, Gamma, Theta. In order
to profitably trade in the Options markets these fundamental tools are a very
big assistance available to the Option traders.
Option Greeks are
calculated using the data available in the option chain which is provided by
the exchanges. Once armed with the Greeks, an options trader can make more
informed decisions about which options to trade, and when to trade them.
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