Option Pricing remains a mystery not only for new and aspiring Traders but even for many old professionals in this Field. 9 out of 10 derivative traders have heard about Option Greeks, but only a few are aware of how these can be applied in the real market. What is more important, most are not aware of the immense power of the option Greeks and what they can do.
The Options Greeks refer to a set of calculations you can use to measure different factors that might affect the price of an options contract. With that information, you can make more informed decisions about which options to trade, and when to trade them. Options Greeks include Delta, Gamma, Vega, Rho, and Theta.
Below is a comprehensive explanation of how various #Option Greeks affect option prices.
1- delta
Delta is a way to measure how much the price of an option changes when the price of the underlying asset changes. In other words, if the price of the underlying asset goes up by 1 point, the delta amount will change the price of the option.
The delta of a call option is positive, whereas the delta of a put option is negative.
Delta value tends to head toward +1 for calls and -1 for puts as the options get closer and closer to being in the money
Good use for hedging the portfolio, determining the hedge ratio requires the use of significant greeks like a delta.
2- Gamma:
The gamma represents the rate of change of the delta about changes in the price of the underlying asset.
The option’s delta will shift by gamma if the underlying asset’s price moves up by 1 point.
There is a positive Gamma for long options (calls and puts)
As an option moves from being at the money to being out of the money or in the money, its gamma lowers.
In this way of thinking, Delta is the velocity, and gamma is the acceleration, just like you learned in physics class.
3-Vega:
Options Greek Vega (v) gauges an option price’s sensitivity to the underlying asset’s volatility. The option price will fluctuate by vega if the underlying asset volatility increases by 1%
A rise in vega generally corresponds to an increase in option value (both calls and puts), whereas a reduction in vega generally corresponds to a fall in option value (Call/puts)
Rising vega is beneficial to option buyers while falling vega is beneficial to option sellers.
4-Rho:
Because options prices are less susceptible to interest rates, Rho () is the least significant Option in Greek. If the interest rate rises by 1%, the option price rises by the same amount
If interest rates rise, the value of the call option rises while the value of the put option falls.
Similarly, if interest rates fall, the value of the call option falls while the value of the put option rises.
5-Theta
Theta is the most important Option Greek for an Option Seller. A way to measure how sensitive the price of an option is to how long it has until it expires. If the no. of days until the option expires goes down by one
Both options have a negative theta. Because the expiry date is fixed, the premium will melt as the options approach their expiry date.
because it has more time until expiry, the value of the option for far expiry will be greater than the value of the option for near expiry
Fund Houses uses the model “FIV” – the “Forward Implied Volatility” is calculated based on 5 different spreads at t1, t2, t3, t4, t5. The rationale behind this model is that the firm must have a fixed rate of return regardless of the market volatility and the theta decay. When the price of the instrument drops, the profitability might expand depending on the deviation of the “FIV” from the sigma. The beauty of such a trading model is you are least bothered about the market volatility. This is an intelligent way to stay ahead of the curve, simply because you incorporate the fact that implied volatility is a variable, not a constant.
Advantage of Option Greeks
We all know that option greeks are the building blocks of the derivatives market. This is primarily how Institutional Traders successfully captures sensitive information like the long-term trend or the short swings way ahead of time. At a retail level, understanding the greeks can help derivatives traders gain 6 powerful advantages.
- Catch the direction of the market with high accuracy.
- Spot the strikes you must trade.
- Understand when these strikes must be traded.
- Identify whether an option strike will expire in the money.
- Intelligently adjust the Delta drift with respect to the shift in the underlying.
- Spot how sensitive options are visa-vis the implied volatility