Options and Candlestick Coaching â Level 1 Session 3
Options and Candlestick Coaching – Level 1 Session 3 - Greeks
Presented by Dave Forster – Nison Certified Options Trainer ™
Introduction to Option Greeks
• • • • • • • • • • •
Why Greeks? Greek List Delta Gamma Trading Edge How Time Decays Theta Vega Greek Dynamics Conclusion Live Demonstration
Why Greeks? Option Greeks are a mathematical model to explain how an option price will change as it’s underlying asset changes Why use option Greeks ?: • Options are called derivatives since their value is derived from the underlying asset. So as an underlying moves, so does the price of any options on it but there may not be a direct 1 for 1 relationship between an option an it’s underlying so the Greeks provide a model for this. • By understanding the Greeks in more detail we can set expectations as to what will happen to our position when changes occur and act accordingly • Understanding Greeks will set proper expectations prior to entering a position. Filtering out trades that do not comply with your desired risk/reward ratio will increase your probability of success. When viewing an option chain, the Greeks are shown from the “Long” (buying) option perspective. When an option is “Short” (selling), the Greeks are the reverse of an option chains values.
Option Greeks • Delta = Impact of underlying price on the options price • Gamma = Change in delta • Theta = Impact of time decay • Vega = Impact of volatility changes • Rho = Impact of interest rates
Delta Defined Delta: The amount by which an option’s value will change if the underlying equity moves by 1 dollar. Delta values range from 0.0 to 1.0 for long calls and short puts, and from -1.0 to 0.0 for long puts and short calls. Therefore, an increase in an equity’s price creates an INCREASE in a portfolios value for long calls and short puts, and a DECREASE in value for long puts and short calls. A decrease in equity value would have exactly the opposite effect.
Delta can be thought of as the probability of an option being in the money at expiration eg: XYZ stock at $20. If a February 25 call has a delta of 0.3, then there is a 30% chance that XYZ will be over 25 at February expiration.
Gamma Defined Gamma: The rate of change of delta with respect to the underlying equity. Gamma is greatest for the strike price that is At The Money (ATM) for a given expira on series. For a given strike price, Gamma decreases as you go further out in time. Gamma reaches it’s maximum at options expiration for the At The Money option. Mathematically it is the first derivative of Delta. Gamma can give you an idea of the sensitivity of Delta and how fast (or slow) that Delta can change.
An Options Trading Edge
Two immutable “laws of nature” in the trading world • Options always decay with time • Markets always move in only one direction at a time • Options strategies can be profitable if an underlying goes up, down, or sideways
Time Decay Dynamics When options decay, it is at a faster rate as expiration approaches
Time Decay Dynamics Time decay is not linear. The rate of decay is related to square the square root of time. • • • •
For example: A 2 month option decays at twice the rate of a 4 month Equation: option SQRT[4] = 2. For example : A 3 month option decays at twice the rate of a 9 month Equation: option SQRT[9] = 3.
• An option will lose a greater percent of its daily value near the end of its life. • Short options have positive theta while long options have negative theta
Theta Defined Theta: Measures the extrinsic value decay of a position. If Theta is a negative number e.g. --0.09 that means that the option will lose 9 cents per day on the value of that trade. If Theta is a positive value, that means that the position will be GAINING on a daily basis. What determines if it’s a positive or negative number? If an option is sold, it’s a positive number but if an option is bought, it’s a negative number. Theta decays the EXTRINSIC value of an option’s price. Short term ATM options have the largest theta values. The difference between theta values of longer term options near the mon ey is not as significant as for shorter term options.
Vega Defined Vega: Quantifies the impact of implied volatility changes on the price of an option. Vega is the amount by which an option’s price changes when implied volatility changes by one percentage point. If implied volatility increases, the price of the option (call/put) will increase, and if implied volatiity decreases the price of the option (call/put) will decrease. Vega can only affect the extrinsic value portion of an option. Vega is higher for options that are further out in time because longer expiration options have more time value than front month options.
How Option Greeks Change
Option Expiration
Delta
So the Option Trader must deal with these changes The Option Seller must: * Maintain or Increase Theta * Realize that Vega will decrease * Be aware of the increasing Gamma effect which counteracts Theta * Keep the Delta Balanced The Option Buyer must: * Maintain or Decrease Theta * Realize that Vega will increase * Be aware of the increasing Gamma effect which counteracts Theta * Keep the Delta increasing
Conclusion All options will expire at options expiration. The question is: Will they be in the money or not? Before expiration, the value of an option will be affected more by the underlying’s price movement and volatility than time decay. ITM options have intrinsic value and extrinsic value. Extrinsic value is commonly known as time value. The five components of an option’s extrinsic value are: •Changes in stock price (Delta) •Changes in implied volatility (Vega) •Passage of time (Theta) •Changes in dividend (if any exist) •Changes in interest rates (Rho) •An option’s price change will be the NET of changes for these five variables.
Presented by Dave Forster – Nison Certified Options Trainer ™
Introduction to Option Greeks
• • • • • • • • • • •
Why Greeks? Greek List Delta Gamma Trading Edge How Time Decays Theta Vega Greek Dynamics Conclusion Live Demonstration
Why Greeks? Option Greeks are a mathematical model to explain how an option price will change as it’s underlying asset changes Why use option Greeks ?: • Options are called derivatives since their value is derived from the underlying asset. So as an underlying moves, so does the price of any options on it but there may not be a direct 1 for 1 relationship between an option an it’s underlying so the Greeks provide a model for this. • By understanding the Greeks in more detail we can set expectations as to what will happen to our position when changes occur and act accordingly • Understanding Greeks will set proper expectations prior to entering a position. Filtering out trades that do not comply with your desired risk/reward ratio will increase your probability of success. When viewing an option chain, the Greeks are shown from the “Long” (buying) option perspective. When an option is “Short” (selling), the Greeks are the reverse of an option chains values.
Option Greeks • Delta = Impact of underlying price on the options price • Gamma = Change in delta • Theta = Impact of time decay • Vega = Impact of volatility changes • Rho = Impact of interest rates
Delta Defined Delta: The amount by which an option’s value will change if the underlying equity moves by 1 dollar. Delta values range from 0.0 to 1.0 for long calls and short puts, and from -1.0 to 0.0 for long puts and short calls. Therefore, an increase in an equity’s price creates an INCREASE in a portfolios value for long calls and short puts, and a DECREASE in value for long puts and short calls. A decrease in equity value would have exactly the opposite effect.
Delta can be thought of as the probability of an option being in the money at expiration eg: XYZ stock at $20. If a February 25 call has a delta of 0.3, then there is a 30% chance that XYZ will be over 25 at February expiration.
Gamma Defined Gamma: The rate of change of delta with respect to the underlying equity. Gamma is greatest for the strike price that is At The Money (ATM) for a given expira on series. For a given strike price, Gamma decreases as you go further out in time. Gamma reaches it’s maximum at options expiration for the At The Money option. Mathematically it is the first derivative of Delta. Gamma can give you an idea of the sensitivity of Delta and how fast (or slow) that Delta can change.
An Options Trading Edge
Two immutable “laws of nature” in the trading world • Options always decay with time • Markets always move in only one direction at a time • Options strategies can be profitable if an underlying goes up, down, or sideways
Time Decay Dynamics When options decay, it is at a faster rate as expiration approaches
Time Decay Dynamics Time decay is not linear. The rate of decay is related to square the square root of time. • • • •
For example: A 2 month option decays at twice the rate of a 4 month Equation: option SQRT[4] = 2. For example : A 3 month option decays at twice the rate of a 9 month Equation: option SQRT[9] = 3.
• An option will lose a greater percent of its daily value near the end of its life. • Short options have positive theta while long options have negative theta
Theta Defined Theta: Measures the extrinsic value decay of a position. If Theta is a negative number e.g. --0.09 that means that the option will lose 9 cents per day on the value of that trade. If Theta is a positive value, that means that the position will be GAINING on a daily basis. What determines if it’s a positive or negative number? If an option is sold, it’s a positive number but if an option is bought, it’s a negative number. Theta decays the EXTRINSIC value of an option’s price. Short term ATM options have the largest theta values. The difference between theta values of longer term options near the mon ey is not as significant as for shorter term options.
Vega Defined Vega: Quantifies the impact of implied volatility changes on the price of an option. Vega is the amount by which an option’s price changes when implied volatility changes by one percentage point. If implied volatility increases, the price of the option (call/put) will increase, and if implied volatiity decreases the price of the option (call/put) will decrease. Vega can only affect the extrinsic value portion of an option. Vega is higher for options that are further out in time because longer expiration options have more time value than front month options.
How Option Greeks Change
Option Expiration
Delta
So the Option Trader must deal with these changes The Option Seller must: * Maintain or Increase Theta * Realize that Vega will decrease * Be aware of the increasing Gamma effect which counteracts Theta * Keep the Delta Balanced The Option Buyer must: * Maintain or Decrease Theta * Realize that Vega will increase * Be aware of the increasing Gamma effect which counteracts Theta * Keep the Delta increasing
Conclusion All options will expire at options expiration. The question is: Will they be in the money or not? Before expiration, the value of an option will be affected more by the underlying’s price movement and volatility than time decay. ITM options have intrinsic value and extrinsic value. Extrinsic value is commonly known as time value. The five components of an option’s extrinsic value are: •Changes in stock price (Delta) •Changes in implied volatility (Vega) •Passage of time (Theta) •Changes in dividend (if any exist) •Changes in interest rates (Rho) •An option’s price change will be the NET of changes for these five variables.
