Knowing the world of options. Though lots of the terms used to describe buying and selling options are the same terms used to describe other types of investments, some terms are exclusive to options. These terms may some time to understand. but there are essential for understanding options strategies.
GREEK
Greek are terms that are used to estimate variations in the prices of options to various market factors such as a change in the price of underlying assets and time to expiration, etc. These terms are named after Greek letters, and they are collectively known as the Option Greeks.
Many traders and investors use the Greeks to compare options and to build strategies. Greeks are calculated are based on mathematical formulas. While they can be used to evaluate possible future prices of options, there’s no guarantee that they’ll hold.
GREEKS ON STOCKS
These Greeks compare the stock’s performance to a benchmark index. They are not usually used in Options.
Beta. It is a measure of how a stock’s volatility changes compared to the overall market. The beta of a stock helps you understand how closely a stock in your portfolio tracks the movement of an index if you’re considering hedging with index options. A beta of 1.5 means that the stock will gains 1.5 points for every point gain in the index—and loses 1.5 points for every point lost in the index.
Alpha. It is the measure of how a stock performs with a benchmark, independent of its beta. A positive alpha indicates that the stock outperformed, and a negative alpha means the stock didn’t perform as well as the index.
A VOLATILE SITUATION
Volatility is a significant component of an option’s price. There are two kinds of volatility: historic volatility and implied volatility. Historic volatility is a measure of how many swings from the mean price underlying asset price has made in the past. The higher the historic volatility, the more the stock price has changed over time. We can use historic volatility to predict how much the stock price may fluctuate in the future, but there’s no guarantee that past performance will be repeated.
Implied volatility is the percentage of volatility that validates an option’s market price. Investors may use implied volatility to predict how volatile the underlying asset will be. Volatility is a key component in the time value portion of an option’s premium. In general, the higher the volatility—either historic or implied—the higher the option’s price will be. That’s because there’s a greater probability of the stock price moving before expiration, putting the option in-the-money.
OTHER MEASUREMENTS
Open interest. The number of open positions for a particular options series at a particular strike price. High open interest means that there are many open positions on a particular option.
Volume: The number of contracts both opening and closing transactions traded over a certain period. A high daily volume means any trader/investors opened or closed positions on a given day.
Liquidity: The more buyers and sellers in the market, the higher will be the liquidity for a particular options series. Liquidity refers to the ease with which an asset can be transferred into ready cash without affecting its market price. If there is demand for buying a particular option, which might increase the premium, or if there are more sellers the option premium will decrease.
GREEKS ON OPTIONS
Option premiums vary with changes in the factors that determine option pricing i.e., factors such as strike price, volatility, term to maturity, etc.
Delta: A measure of how much an option price changes when respect to the change in the price of the underlying asset is called delta. The delta of an option varies over the life of that option, depending on the underlying stock price and the amount of time left until expiration.
Delta = Change in option premium/ Unit change in the price of the underlying asset
Delta for a call option buyer is positive. This means that the value of the contract increases as the price of underlying rises. To that extent, it is rather like a long or ‘bull’ position in the underlying asset. Delta for call option seller will be the same in magnitude but with the opposite sign (negative).
Delta for a put option buyer is negative. The value of the contract increases as the price underlying falls. This is like a short or ‘bear’ position in the underlying asset. Delta for put option seller will be the same in magnitude but with the opposite sign (positive).
Therefore, delta is the degree to which an option price will move given a change in the price of the underlying all other factors being the same.
Delta is expressed as a decimal between 0 and +1 or 0 and –1. For example, a call option delta of 0.5 means that for every Rupee increase in the underlying, the call premium increases by 50 paisa. A delta between 0 and –1 refers to a put option since put premiums fall as underlying price increases. So, a delta of –0.5 would mean that for every Rupee increase in the underlying price, the put premium would be expected to drop by 50 paisa.
The knowledge of delta is important for options traders because Delta is heavily used in margining and risk management strategies. The delta is often called the hedge ratio, e.g. if you have a portfolio of ‘n’ shares of a stock then ‘n’ divided by the delta gives you the number of calls you would need to be short (i.e. need to write) to create a hedge. In such a “delta neutral” portfolio, any gain in the value of the shares held due to a rise in the share price would be exactly offset by a loss on the value of the calls written and vice versa.
Theta: The rate at which premium decays while the passage of time. Theta is the decrease in option price due to a decrease in a day to expiration. It is a rate of time decay. Theta is commonly used to gain an idea of how time decay is affecting your option positions. As time decays, options prices can decrease rapidly if they’re out-of-the-money. If they’re in-the-money near expiration, options price changes tend to mirror those of the underlying stock.
Theta = Change in an option premium/ Change in time to expiry
Theta is usually negative for a long option. Other things being equal, options tend to lose time value each day throughout their life. This is because of the uncertainty element in the price decreases.
Rho: Rho is the measure of change in option price given a one percentage point change in the risk-free interest rate. Rho calculates the change in an option’s price per unit increase in the cost of funding the underlying.
Rho = Change in an option premium/ Change in cost of funding the underlying
Vega: An calculates of how much an option price changes when the volatility in the market changes. In general, greater volatility means a higher option price. Vega is also sometimes referred to as kappa, omega, or tau.
GREEKS ON GREEKS
These Greeks are derived from the existing option Greeks (as discussed above). This work as secondary measurements, showing how a particular Greek changes as the option changes in price or volatility.
Gamma: It is a measurement of how delta changes when the price of the underlying stock changes. In short, gamma is the delta of an option’s delta. This is called a second derivative option about the price of the underlying asset. It is calculated as the ratio of change in delta for a unit change in the market price of the underlying asset.
Gamma = Change in an options delta/ Unit change in the price of the underlying asset
Gamma checks the acceleration of the delta, i.e., it signifies the speed with which an option will go either in-the-money or out-of-the-money due to a change in the price of the underlying asset.
OTHER TERMS
HEDGING : Hedging an investment means you protect yourself against losses, usually with another instrument that requires additional capital. With options, you might hedge your long stock position by writing a call or purchasing a put on that stock. Hedging is often compared to buying insurance on investment since you spend some money protecting yourself against the unexpected move in the price of underlying.
LEVERAGE : Leveraging means, you use a small amount of money to control an investment that’s worth much more. Stock market traders have leverage when they trade on margin, committing only a percentage of the capital needed and borrowing the rest.
As an options trader, you have leverage when you purchase options. Profit from a change in the underlying stock’s price at a lower cost than if you owned the stock. Leverage also means that profits or losses may be higher when calculated as a percentage of your original investment.