In the last article, we got to understand the basics of what moves an option’s premium. There are several factors like implied volatility, moneyness and time to decay that affect its price. In this article, we take a detailed look at each of the options Greeks and how they work.
Before we begin…
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For every 1 Re change in the price of the underlying securities or index, Delta estimates how much an option’s price can be expected to vary. A Delta of 0.40, for example, suggests that the option’s price will move 40 paisa for every 1 Re movement in the price of the underlying stock or index. As you may expect, the higher the Delta, the greater the price variation.
Traders frequently utilise Delta to determine whether an option will expire in the money. A Delta of 0.40 is taken to signify that the option has a 40% chance of being ITM at expiration at that point in time. This isn’t to say that higher-Delta options aren’t profitable. After all, you might not make any money if you paid a high premium for an option that expires ITM.
Delta can alternatively be thought of as the number of shares of the underlying stock that the option mimics. A Delta of 0.40 indicates that if the underlying stock moves 1 Re, the option will likely gain or lose the same amount as 40 shares of the stock.
Call Options
The positive Delta of call options can range from 0.00 to 1.00.
The Delta of at-the-money options is usually around 0.50.
As the option’s price goes deeper into the money, the Delta will rise till it eventually reaches 1.
As expiration approaches, the Delta of ITM call options will approach 1.00.
As expiration approaches, the Delta of out-of-the-money call options will almost go down to 0.00.
Put Options
The negative Delta of put options can range from 0.00 to –1.00.
The Delta of at-the-money options is usually around –0.50.
As the option goes deeper ITM, the Delta will fall (and approach –1.00).
As expiration approaches, the Delta of ITM put options will reach –1.00.
As expiration approaches, the Delta of out-of-the-money put options will almost go down to 0.00.
Gamma
Gamma represents the rate of change in an option’s Delta over time, whereas Delta is a snapshot in time. You can think of Delta as speed and Gamma as acceleration if you remember your high school physics lesson. Gamma is the rate of change in an option’s Delta per 1 Re change in the underlying stock price in practice.
We imagined a Delta of.40 choice in the previous case. The option’s Delta is no longer 0.40 if the underlying stock moves 1 Re and the option moves 40 paise with it. Why? The call option is now considerably deeper ITM, and its Delta should move even closer to 1.00 as a result of this 1 Re move. Assume that the Delta is now 0.55 as a result of this. The Gamma of the choice is 0.15, which is the difference in Delta from 0.40 to 0.55.
Gamma falls when an option acquires further ITM and Delta approaches 1.00 since Delta can’t reach 1.00. After all, when you near top speed, there’s less room for acceleration.
Theta
If all other factors remain constant, theta informs you how much the price of an option should decline each day as it approaches expiration. Time decay is the term for this type of price depreciation over time.
Time-value erosion is not linear, which means that as expiry approaches, the price erosion of at-the-money (ATM), just slightly out-of-the-money, and ITM options generally increases, whereas the price erosion of far out-of-the-money (OOTM) options generally drops.
Vega
Vega is the rate of change in an option’s price per one percentage point change in the underlying stock’s implied volatility. Vega is used to estimate how much the price of an option would vary with respect to the volatility of the underlying.
More information on Vega:
One of the most important elements impacting the value of options is volatility.
Both calls and puts will likely lose value if Vega falls.
A rise in Vega will normally raise the value of both calls and puts.
If you ignore Vega, you may end up paying too much for your options. When all other conditions are equal, consider purchasing options when Vega is below “normal” levels and selling options when Vega is above “normal” levels when choosing a strategy for options trading. Analysing the implied volatility with respect to the historical volatility is one approach to analyse this.
Implied volatility
Despite the fact that implied volatility is not a Greek, it is still important. Implied volatility is a prediction of how volatile an underlying stock will be in the future, but it’s only an estimate. While it is possible to predict a stock’s future movements by looking at its historical volatility, among other things, the implied volatility reflected in an option’s price is an inference based on a variety of other factors, including upcoming earnings reports, merger and acquisition rumours, pending product launches, and so on.
These are the different option greeks that you need to use in conjunction with other bullish and bearish strategies and mathematical models that you might use to determine market moves.
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