Option trading is the process of buying and selling options in the stock market. Option trading is an exciting process and almost every market participant has at least experienced the thrill of trading options, almost all the time with unsatisfactory results.
Trading options is like driving at a very high speed, it may be thrilling but it is extremely risky and most of the time results in accidents. To avoid such accidents and systematically profit from such ventures, an option trader seeks to improvise his/her trading by using as many tools as are available for disposal. The most important of such tools are the Option Greeks and they are usually the first metric looked upon by option traders.
Option Greeks are the most powerful tool for an option trader. They help an option trader make informed trading decisions. Thereby, providing them with an unparalleled edge to trade options.
Option Greeks are computed using various pricing models. These models seek to estimate the influence of the various market conditions on the price of an option. Together they provide a holistic view.
(Related blog: Option Trading Strategies)
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
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.
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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.
(Related blog: Wholesale Price Index)
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.
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.
(Must read: Introduction to Technical Analysis)
Rho is a formula that calculates the predicted change in the price of an option based on a one-percentage-point change in interest rates. If the risk-free interest rate rises or falls, it informs you how much the price of an option should rise or fall.
As interest rates increase, the value of call options will generally increase and the value of put options will usually decrease. This is because the price of the underlying asset will generally increase with an increase in the interest rate. For these reasons, call options have positive Rho and put options have negative Rho. Rho is generally not as widely-used a factor in the price determination of options, specially in the short term, as are the other Greeks.
Rho is particularly important to be considered just around an event like the Federal Open Market Committee (FOMC) meeting in the US or the Monetary Policy Committee (MPC) meeting in India and for longer term considerations.
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This blog discussed the 5 Option Greeks- Delta, Gamma, Theta, Vega, Rho. 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.