Understanding the Option Greeks
Option prices are dependent on various Greeks or factors that decide whether the option price will move upside or downside , this is a must for all option traders before they start trading options. Option greeks are very important and if one understands it well , he can actually benefit by regular option trading.
The Greeks are
- ** Rho
For trading purposes, we will concentrate on Delta, Gamma ,Vega and Theta.
Delta – Delta is measured as a change in option price basis change in the underlying stock / index. So, let’s say Nifty spot is 11250 in Aug series and your view is Nifty will cross 11,300 well before the expiry.
You are betting against three things ( Price movement , Volatility , Time value – Since Options cannot be rolled over hence they have negative time value i.e as maturity approaches the option looses value )
Coming back to Delta – Now suppose Nifty 11300 CE Aug 2018 Series has a delta of “1” and you bought the option for 150 per lot . This signifies that option price will increase / decrease by 1 point as per the movement of the nifty index . If nifty ends at 11,275 ( Spot ) we assume the option price shall increase by 25 points to 175 . (Ignoring other Greeks for sake of simplicity).
Many traders or investors indulge in delta neutral strategies wherein the continuously buy / sell options in order to maintain the neutral delta of the portfolio and protect it.
How to use Delta for picking your strike for trading options ?
Its intuitive that ATM options will have delta close to 1 , i.e option price will move as per the underlying with little deviation . OTM and Highly OTM options will have delta close to 0 i.e option prices will move insignifincatly . ( Reason why many investors lose money is because they trade OTM options having delta close to “0” , hence their option price never moves up and slowly the time bomb ( theta ) erodes the option value )
Gamma : Gamma is the second order derivative of the underlying , its measure of change in delta basis the change in the underlying. Gamma is largest when the options is ATM , its because here the Delta is also ~1 so changes are minimal in delta . For deep in the money options the Gamma is small.
Advanced hedgers use gamma more than delta to hedge their positions. In simple words gamma can be used to as a prediction tool for probability of the options being favorable for the option buyer. High gamma is useful for long Straddle players as gamma increases as volatility increases and high gamma is often taken as a sign of the underlying volatility.
For traders who bet against the volatility and assume the stock / index will be range bound , they closely track the gamma. As a higher gamma indicates that volatility is increasing and traders should reverse their positions. In financial stress/ crisis situation many people would be unable to unwind their positions at favorably prices since the gamma will suddenly increase and take away the profit.
- High value of gamma is favorable for people who are long on volatility .
- Traders who sell options call / put could be at loss if volatility fires upwards , this sudden change in the option price is known as Gamma risk
- General convention is higher gamma is riskier then lower gamma
VEGA – Change in Option price due to change in Volatility of the underlying.
One of the key principle that I have highlighted in my earlier articles is that volatility is a key driver in option pricing . Guys , FNO is all about speculation and if a stock / index doesn’t have a lot of volatility the speculation range is reduced and hence the prices don’t move significantly and buyer of options lose money .
So while choosing your option and strike you have to see whether the underlying is volatile enough so that people write more calls and the options has some good Open interest at the end of the day.
Remember the option price is directly proportional to Volatility, more volatile the underlying the more chances of the option trade being profitable.
THETA: Change in option price is dependent on the number of days to expiry (Often known as ENEMY of option buyers)
This option Greek has a negative value through out its life. Its because option cannot be rolled over to next month and needs to be settled / squared off. So, betting against this Greek is most dangerous, people often don’t realize that this Greek is solely responsible for eating your option premium in times where there is low volatility and liquidity in the market.
Theta is time decay, i.e. as option approaches maturity it will reduce the option price. So even if your Delta and Vega are positive and there is less time to maturity, the theta will negate the gains of delta and Vega.
There are some traders who sell options only on expiry day they know at the end of the day the option will lose value because theta reaches its maximum and effects of Vega is diminished. These traders categorically sell options on expiry day and eat huge premiums of newbie traders
Have any questions , please comment below !