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Most retail option traders in India do not know option Greeks or do not care for them. Option Greeks are very vital part of options trading. If you do not understand them, than it is very important to know about them. At least you should have an idea of what they are. Lets discuss them.
The Five Option Greeks:
It is the amount an option price will move with every 1 point move in the Index/Stock. If expiry is not near, Delta movement is NOT 1 point increase with 1 point increase in the stock. Which means if the stock moves 1 point up, depending on the strike price of the option, the option will move less than 1.
The reason is that you buy option at a lesser price than the stock in cash for the same lot size, so why should you get profits equal to someone who bought the same stock in cash? Of course option buyer’s losses are also less than stock buyers’.
At the money (ATM) options usually have a delta of 0.5. If the stock moves up 1 point – the price of the ATM option will go up by 0.5. In The Money options have more Delta than out of the money options. Deep In The Money options move almost 1 to 1 with the stock. This is reason why some traders prefer buying deep ITM options. If right ITM options will make more than ATM or OTM options.
As an example. Lets assume Nifty at 8000. The 8000 strike price of calls and puts will have Delta of 0.5. Similarly 8100 CE (OTM) may have a delta of 0.4, 8200 CE (far OTM) may be 0.3, and 7900 CE (ITM) may have a Delta of 0.6. Note how they are changing. Deltas are assumed here not real – but you get the idea.
As expiry nears Delta of all in the money options will move very closely with the stock price as there is no time value left. When expiry is very near Delta of all ITM options move towards 1. Delta of all Out Of The Money (OTM) options will move towards zero. Therefore on expiry day the premium of all Out Of The Money options becomes zero and they expire worthless.
Note: Some traders think that a Delta of 0.1 means the option has 10% chance to expire In The Money. Or 0.5 means the option has a 50% chance of expiring In The Money. You got the idea. This is very important figure for option sellers. I do not have any data to prove this to be true. So please take precaution while selling option even if it has a Delta of 0.1.
With the movement of the stock someone has to change the price of Delta as the option moves from ATM to OTM and then back to ATM to ITM.
In the example that we described above, when Nifty moves to 8100 – the 8000 CE becomes In The Money and its Delta increased from 0.5 to 0.6, similarly Delta of 8100 CE increased from 0.4 to 0.5. Gamma is responsible for this change.
Gamma controls the Delta. It is the mathematical formulae (a software) that decides the change in Delta based on a 1 point change in the stock. If Nifty goes back to 8000 – the 8000 strike will again become Delta 0.5.
This factor is known by most traders. Theta is the Time Factor in the option premium. This time factor moves towards zero as expiration approaches. Theta is the amount the premium will decrease for a one-day change in the time to expiration. Theta works on holidays and non-trading days too. Theta behaves differently for different strike prices.
One important thing that needs mention. Considering options expiring in 30 days – Theta for deep OTM (Out Of The Money) and Deep ITM (In The Money) options decrease faster in the first 15 days and almost nothing is left for the last 10 days. However ATM options (and the near strike prices) behave exactly opposite. The speed of decrease in Theta is almost constant till the last 5 days – after this the speed increases rapidly. In the last 1 hour it is the maximum.
Compare Theta to the melting of ice. If you take some ice out of your freezer and observe, you will see that for the next few minutes almost nothing happens, then slowly the ice starts melting. After 10-15 minutes the speed if ice melting increases. The last 2 minutes are pretty fast when the ice totally melts. Theta behaves the same way especially for ATM options.
Option sellers are the one who love to see the Theta of options decreasing – because this is what makes money for them. Most option sellers sell out of the money options – which means they are only selling Theta. They buy back the options when Theta decreases in value significantly to make a profit.
Is the volatility factor. Vega is the amount option prices will change for one point change in implied volatility. It is a measure of fear or uncertainty in the markets. When a big news is expected – there is uncertainty in the markets – so the volatility too increases. When volatility increases option prices for both calls and puts also increases. When volatility decreases option prices for both calls and puts also decreases. Vega only effects the time value of the options not its intrinsic value.
For example if Nifty is at 8000. Assuming the 7900 call option is available at a premium of 130, then the intrinsic value of this option is 100 (the difference between the spot price and the strike price of the option). The time value is 30. When Vega increases, only the time value is affected. This 30 can increase to say 32 depending on the volatility increase.
Similarly when the news is out and uncertainty dies down, volatility decreases. This in effect decreases the premium of the options. This is where most trades lose money. Vega has such a big effect that sometimes even if the direction is right, an option buyer loses money because Vega decreased.
This happens mostly with call option buyers. Usually when the markets go up, the volatility decreases. Call option buyers are up against Time (Theta), and Volatility (Vega). OTM call option buyers lose money even if the stock goes up because by the time it goes up a significant portion of the premium would already have been eaten by Theta and the decrease in Vega will also reduce the premium.
For them to make money the speed of the stock going up is very important. However put buyers are in slightly advantageous position because usually when the markets fall, the Vega increases and they can benefit. However they are also up against Theta. Here too speed matters, though not as important when the stock moves up.
I am sure you now understand why most option buyers lose money.
In India volatility is called India VIX. NSE (National Stock Exchange) has allowed Vega Trading too. Right now only Futures trading is allowed. But I think too much capital is required for margin. Right now it is only for (HNIs) High Net worth Individuals. India VIX can be found here:
Lower end of VIX (when sellers get less premium): 10-15
Average VIX: 15-20
High VIX: 20 and above
As an example on 12-May-2014 when the India VIX hit a high of 39.3 because the election results were due, and spot Nifty closed at 7014 the ATM call was at 294 and the put at 244. Total premium a seller would have got: 294+244 = 538
Today is 13-Nov-2014 (almost same days left for expiry for the current month). India VIX is 13.80 (64.88% less than 12-May-2014). Nifty closed at: 8357. Here are closing prices for both 8300 and 8400 strike options.
8300 CE: 122
8300 PE: 42
Total: 122+42 = 164 (69.51% less than total of the ATM options on 12-May-2014)
8400 CE: 61
8400 PE: 79
Total: 61+79 = 140 (73.97% less than total of the ATM options on 12-May-2014)
As you can see for the same Theta left, when Vega is down 65%, the option premium also reduces by almost the same amount.
I hope now you understand how important Vega is for option traders.
Why does premium of options increase when Vega increases?
The reason is simple. When there is uncertainty in the markets no one knows exactly where the markets are heading. The risk during these times are more. The risk is much more for the option seller. Why? Because they are willing to take unlimited risk for a limited profit. When the markets are uncertain and the premium they are getting is not sufficient why would they sell an option and take unlimited risk for a small profit?
For example on 12-May-2014 if the total premium of the ATM strikes was just 150, do you think anyone would have sold these options? If there are no sellers, there can’t be any buyers. And if this happens – options trading will cease to exist. Therefore when Vega increases the option premium also increases to lure the sellers.
Is the interest rate offered at the banks for a fixed deposit of 1 year. It is the amount an option value will change with one percentage-point change in interest rates. As mostly the interest rates are same for a long period, Rho does not have a big impact on the option prices. Since interest rates are not important lets not discuss this further.
How you can get the Option Greeks while trading?
Your broker should be able to provide you with an option Greek calculator if you are approved to trade options. You may also look online. You need to put in the values like strike price, time left, interest rates etc and the calculator should return the Option Greeks.
How to trade with the help of Option Greeks?
This is a very big topic. You will find books written on this topic alone. However I will tell you what most retail traders do in the US. By default in the US all brokers show ALL the Greeks on a traders screen. They need not use any calculator. Unfortunately in India there is not a single broker that shows them by default. If you know any please mail me or write in the comments.
If they want to sell options, they sell option that has Delta of less than 0.15. Which means they sell deep Out Of The Money options. The idea behind this trade is that the chance of this option to expire worthless is 85%. (1-0.15 = 0.85 or 85%)
If they want to buy, they buy options that have delta of 0.5 or more. Which means they buy At The Money or slightly In The Money Options.
Some traders sell both call and put options – mostly out of the money options. These traders try to keep their trades at Delta Neutral. Again this is a very big topic out of scope of this article. Still I will try to explain in a simple way.
Delta Neutral means keeping Deltas of all the options they sold same with any movement of the stock.
For example if stock moves up – the Delta of the call option will increase. So they will move the position a few points up. Essentially booking profits in the puts and booking loss in the calls – but maintaining the Deltas of the calls and puts more or less same. The idea is to profit when expiry nears. The Theta will decrease rapidly of both the calls and puts when expiry nears. Ultimately both the options will expire worthless.
Profits or losses are known only on the expiry day, or when the trade is closed. If all the delta neutral adjustments resulted in profits then the trader is in profit, else he loses.
Some people write software to automate this trading. Yes you can write a piece of software to automate your trading and strategies. Benefit is that emotions are not involved. I have rarely come across a person who made money doing automated trading.
Frankly it is very challenging to keep a trade Delta neutral. You need to keep a watch on the stock every time and be ready to shift your trades with few points movement in the stock. Lots of trading is involved therefore lot of brokerage also needs to be paid. Profits or not, your broker will thank you for being a Delta Neutral trader. 🙂
If you are on a job or a busy person it is humanly impossible to keep changing your trades to be Delta Neutral. And there is no guarantee of profits either. We don’t trade to waste time and lose money too right? If you are busy and don’t want to trade too much and are happy with small profits month after month I recommend my course. Its much better than wasting money on losing trades that teach you nothing.
This came out to be a pretty long post, still this is tip of an iceberg as far as Option Greeks are concerned. Though, I hope after reading this article you will have some idea about them.
Do ask any questions on them in the comments section. Do you look at Option Greeks before taking your decision on option trading?
More information on Option Greeks can be found here:
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