Trading Tips – Option Greeks

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OPTION GREEKS

What are Option Greeks?

Option Greeks are mathematical outputs from an Option Valuation Model which help you to understand the possible future movement in Option Values based on various underlying parameters. Greeks help you in possible predictions of Option Values and help you to fine tune your buy sell hedge decisions much better. While Greek formulae look heavily mathematical and formidable, they are not as difficult as they appear.

Which are the common Greeks used?

The common Greeks are Delta, Gamma, Vega and Theta.

What does Delta indicate?

Delta stands for the change in the Option Value for a given change in the price of Shares. For example, if the Delta of a Call Option is 0.65, the meaning is:  If the share price moves up by Re 1.00, the Call Option will rise up by Rs 0.65. Call Option Deltas are by definition positive indicating that a rise in share price will also result in a rise in the Option Value. Put Option Deltas are by definition negative, indicating that a rise in share price will result in a fall in the Put Option Value.

What does Gamma stand for?

Gamma stands for the change in Delta itself for a given change in the share price. Technically, it is called a second order derivative. Let us take an example. For a given share price, the Delta of an Option is currently 0.65. The Gamma at the moment is 0.02. This means:  If the share price moves up by Re 1.00, the Option Value will move up by Rs 0.65 (meaning of Delta as discussed above). When this happens, the Delta itself will become 0.67 (i.e. 0.65 as earlier plus 0.02). Thus, the Gamma predicts movements in Delta given changes in the underlying share price.

What does Vega indicate?

Vega indicates impact of Volatility. As we have discussed earlier, Volatility has a positive impact Option Values. Both Calls and Puts will increase in Value if Volatility rises and fall in Value if Volatility falls. Vega determines the increase or decrease in Value with precision. For example:  if Vega is 0.09, the meaning is that the Option Value will rise by Rs 0.09 for an increase of 1% in Volatility. If the current Volatility of Satyam is 35% and the Value of an Option is Rs 11, the implication is that were the Volatility to move up to 36%, the Option Value would rise to Rs 11.09. Conversely, if Volatility were to fall, the Option Value will correspondingly decrease.

What does Theta stand for?

We have discussed earlier that Option Values will decrease with passage of time. The Time Value component of the Option will gradually move down to zero on expiry day. Theta determines precisely how much the value of the Option will decrease by passage of time. For example, if the Theta of an Option is –0.17, this means the value of this Option will decrease by Rs 0.17 on passage of one day.

Are there other Greeks?

There are other Greeks like Rho and third order derivatives which are not very practical for the Indian scenario right now. The relevance of such Greeks would be applicable in a highly sophisticated market and for institutional players. For retail investors, the four Greeks discussed above should suffice.

How do I apply these Greeks in my investing practice? Shall we deal with application of Delta first?

Delta is the most important Greek and the most commonly applied one. Delta tells you how much the Option will move. In most cases, you have a view and you have chosen to trade in Options based on that view. You will however make a profit only if the Delta is sensitive enough.

Let us take an example. Satyam is currently quoting at Rs 235. You have a choice of various Call Options as under. You are bullish on Satyam.

Strike Prices Option Value Delta
200 48 0.80
220 28 0.55
240 8 0.45
260 4 0.25
280 2 0.05

A common question which arises in most minds is which Option should I buy?

Which one would most retail investors buy?

Many investors buy the far out of the money call (Strike Price 280) on the ground that it is cheap (only Rs 2).

Is that the correct decision?

It depends on how bullish you are. Do you expect Satyam to move up from the current level of Rs 235 to as high as Rs 280 or higher in the next fortnight or so (assuming that a fortnight is left for expiry)? If yes, then do go ahead and buy the Rs 280 strike Call. But if not, then you are making a mistake.

What mistake?

Well, you buy the Call for Rs 2. You pay a brokerage on the Notional Contract Value which itself comes to Rs 0.25 (let us say). Now Satyam does move up. But it moves up from Rs 235 to say Rs 248 in the next 10 days. Where do you think your Option will be quoting at?

Where?

Well, it would most probably be quoting at below Rs 2.

Why? Option Prices are supposed to move up when the Share price moves up?

Yes, you are perfectly right. But look at the Delta. The Delta is only 0.05. This implies that for Satyam moving up by Rs 13 (Rs 235 to Rs 248), the Option Value will move up by Rs 13 * 0.05 i.e. Rs 0.65. In the meantime, there is the impact of Time on the Option. 10 days have passed out of a total of 15 days. Hence, the Time value would have reduced. Thus, it is most probable that the Option is quoting below Rs 2 at that time.

Now do you realize what the Delta is telling you? It is telling you that though you are bullish, though you might be right in your view, this particular Option is not sensitive to mild or moderate bullishness at all. You will lose money here.

Which Option should I buy then?

If you are mildly bullish or moderately bullish, you should go in for the in-the-money options or at-the-money options. These will rise faster and smartly with the underlying price rising. Further, you might find that the deltas improve with passage of time.

Technically, you can understand that you are almost buying the share itself (but a fraction of the price) if you buy high delta Options. For example, if you buy the Satyam 200 Strike Call (with a Delta of 0.80), you are almost buying Satyam itself but at a price of Rs 48 rather than Rs 235. If Satyam moves upto to say Rs 250 in the next 10 days, the Option value will move up by 80% of that appreciation (i.e. Rs 12). Of course, the value will get diluted due to passage of time too. But the basic appreciation is much higher than the Rs 280 call.

It is believed that most professional players buy in the money and at the money options while amateurs buy out of the money options. As a result, amateurs might be losing most of the time.

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