Options can be termed as a multi-dimensional trading instrument and trading in options will feel irrational most of the time if you don’t have an understanding of option greeks. The price of options premiums are based on multiple factors and each of them holds equal importance with changing market conditions. The understanding of each greek up to some extent will make changing CE and PE options premiums seem a bit rational. It is not absolutely necessary to know every greek in detail to trade options but it’s always good to know about it to think rationally in certain situations.
Mainly there are five option greeks
- Delta
- Gamma
- Theta
- Vega
- Rho
Before understanding these greeks its important be get familiarized with three terms i.e
- In the money
- At the money
- Out of the money
In simple terms, the spot price of Nifty is at 17900 now the 17900CE and 17900PE are called At the money (ATM) option strikes, 18000CE and 18000PE are called out of the money (OTM) options and 17800CE and 17800PE are called In the money (ITM) options.
Well in technical terms there is a formula to derive the ATM, ITM, OTM options. In the options trading for beginners article we have mentioned the concept of intrinsic value if you do not know what is Intrinsic value and how to derive it then please click here to read the following Article.
Anyways Intrinsic value is the amount of money you make if you are exercising the options contract.
Call Strikes Intrinsic value = Spot price – Strike Price
Put Strikes Intrinsic value = Strike Price – Spot Price
- The Strike which is closer to the Spot is called At the Money strikes.
- The Strikes with intrinsic value zero (Intrinsic value cannot be Negative) are Out of the money option strikes.
- The Strikes which has a non-zero intrinsic value is called In the money Option strikes.
Now with the understanding of ATM, ITM, OTM options let us look at the Options Greeks.
Delta
Delta describes the rate of change of options premium based on the movement in underlying stock or instrument. Delta is a value that ranges between 0 to 1 for the call option and 0 to -1 in the case of put options.
So how is the value going to make an effect on option premiums? Expected change in option premium = Option Delta * Points change in underlying
For every 1 point move in the underlying, the ITM options will get the maximum impact and OTM options will get the least delta effect. The ITM options will act like futures and movement in either direction is directly proportional to the movement of in the money options.
If you are 100% sure about the direction of the trend of the market then buying ATM or slight OTM option strikes will give you the maximum delta acceleration and results in bigger returns in terms of an option buyer’s perspective. Or Theoretically saying if the delta of an ATM strike say, .52, then on a move of 100 points the premium of the strike will gain 52 points. But in practice, it will never be 52. Sometimes it is more than 52, sometimes less due to the effect of other factors.
Gamma
We have seen that a movement of 100 points will move the options price by 50 points if its delta value is 0.5 but it’s not the same always, you must have noticed the price won’t move 50 points sometimes it’s due to the gamma effect. Gamma effect can occur due to any positive or negative news which creates a panic situation that changes the sentiment immediately.
Instead of moving 50 points sometimes the premiums shoot up to 60 due to the gamma effect.
Gamma captures the rate of change of delta,
Delta is the 1st order derivative of premium = Rate of change of Underlying assets
Gamma is the 2nd order derivative of premium = Rate of change of Delta.
Theta
The options premium is calculated mainly based on the time and the intrinsic value. Time value plays a major role for the premium price fluctuations and there are a lot of traders mainly nondirectional players who trade only to gain time value points from the options premium. The higher the expiry period the higher the time value and vice versa.
All options – both Calls and Puts lose value as the expiration approaches. The Theta or time decay factor is the rate at which an option loses value as time passes. Theta is expressed in points lost per day when all other conditions remain the same. Time runs in one direction, hence theta is always a positive number, however, to remind traders it’s a loss in options value it is sometimes written as a negative number. Theta is the best friend for most of the option sellers and the worst enemy for the option buyers.
RHO
Rho is the effect caused in the options premiums due to change in the interest rates. Certain countries have lower interest rates but some have higher interest rates. So one of the factors that decide the options price in the economy is the interest rate in the economy. Rho does not have a direct effect on the options prices as the interest rates remain fixed for a certain period of time. The RBI meets every two months to review the rates. This is a key event that the market watches out for. The first to react to rate decisions would be interest-rate sensitive stocks across various sectors such as – banks, automobiles, housing finance, real estate, metals, etc.
Vega
Vega or volatility is a major factor that affects the options premiums frequently. I’ve seen most of the traders checking the Implied volatility of individual strikes as well as India Vix before taking a trade. Mostly I’ve seen the IV of put options more compared to Call options because of overnight risks carried by the Put option sellers. The implied volatility will be really high when the market turns volatile eg. during the covid 19 period. And will be reasonable when the market is stable. India Vix was 90 during the pandemic period and nowadays it is in the range of 12-18.
Also, you must have noticed that despite the market falling the options premiums of the OTM call strikes are increasing, this can be understood by the greek vega. Another reason is delta, of course, the OTM options have a delta of 0.1 so a massive move in the market won’t make the premiums change a lot.
Volatility Smile
Theoretically speaking, all options of the same underlying, expiring on the same expiry day should display similar ‘Implied Volatilities’ (IV). However in reality this does not happen. The image below explains the levels of IV compared with different strike prices.
Having a better perspective and knowledge of Option Greeks will support you to make better trading decisions, it can help you take better entry and exit on the trade. Suppose when the IV is high the options premium value will be comparatively higher, which will be in the favor of an Options seller not for an Option Buyer. An Option buyer has to make entry at a lower IV value with a good directional move targeted to maximize his returns. Similarly, on an expiry day, theta value drops sharply which favors an Options writer when the market consolidates.
Options trades for various market conditions are deployed by keeping an eye on the Greek values of the trade, to ensure it aligns with our perspective on the market movement. Having a good knowledge of Greeks will also help you to make better adjustments if the trade goes against your view, like maintaining the Delta neutral position, positive vega trade, negative vega trade, etc. We will discuss more about options strategies and Adjustments in upcoming articles, till then observe the Option chain and Greek values, their fluctuations on the market for a few days to get yourself a better understanding of them in the live market, and their impact on the option premium.
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