Options Greeks are metrics to measure the impact of these different metrics that affect the price of options contracts. The price of an options contract can change due to several factors including the price movement in the underlying asset.
Options contracts and options greeks
Options contracts are arrangements between two parties that facilitate potential transactions of an underlying asset at a specific price within a specified timeframe.
An Options contract offers the buyer of the contract an opportunity to buy or sell the underlying asset at a specific price (strike price) until the expiry date of the contract for American options and after the expiration date for European options.
Options are not obligatory assignments for investors. Some investors use options contracts for hedging trades rather than to make profits. However, investors can use options contracts for speculations and profits as well. As it allows them to leverage their capital, and achieve even higher returns.
There are two types of options contracts
In a call option contract, a position for a transaction is opened by both parties. The buyer of the call option pays a premium to the seller to assume the obligation of selling the underlying asset at or before the contract expiry date, at the agreed strike price.
Therefore, the buyer of the call option holds the option to buy shares at the strike price. The call option contract works in favor of the buyer if the underlying asset price moves up.
For sellers of call options, their profit is the premium received through writing the call option.
A put option contract offers the investor an opportunity to sell an underlying asset at a specified price.
Investors look to make profits when they anticipate a decrease in the price of an underlying asset. They can make profits when the stock prices fall below the strike price if they buy a put option.
Investors can then sell the put option contracts to other investors.
Key Factors Affecting Options Contracts
Options contracts come at a cost called option premium. They can be converted to an underlying asset at the strike price.
Several factors contribute to the price fluctuations of an underlying asset. Derivatives and options contracts are then affected due to a change in the price movement of an underlying asset. Or conversely, the underlying asset price may also be affected by the volatility of derivatives associated with the underlying asset price. One of the examples of this is a gamma squeeze.
What Are Options Greeks?
Options Greeks are financial measures that measure the sensitivity of the price of an underlying asset in relation to their relevant metric. The most important metrics are price, time decay, and volatility of an underlying asset.
When investors know how prices will change in relation to these factors, they can make informed decisions. Thus, options greeks measure these factors and help investors make better decisions.
Investors can predict options pricing using options greeks and other tools. In order to anticipate future options price movements. Particularly, options greeks help investors analyze how the option price will move in relation to an underlying risk factor.
However, options greeks can be used in risk hedging strategies as well. Investors can hedge their options contracts using options greeks. They can arrange balancing options contracts that neutralize each risk factor for an option or a portfolio of options collectively.
The most widely used Greeks are Delta, Gamma, Vega, and Theta.
|Greek||Dependent Variable||Independent Variable||Measure|
|Delta||Option Price||Underlying Asset’s Value||Impact of Change in the underlying asset’s price|
|Gamma||Delta||Underlying Asset’s Value||Rate of Change of Delta|
|Theta||Option Price||Time Decay||Impact of time remaining to expiry|
|Vega||Option Price||Volatility||Impact of Change in Volatility|
Let us now discuss each of these in detail.
Delta is the measure of the price change for an options contract with respect to a change in the underlying asset’s price. It means when the price of an underlying security (stock) changes by $1, the options price will change by (Δ) DELTA amount.
The value of delta is calculated between –1 to +1. For call options, the value of delta will range from 0 to +1. Similarly, for the put options, the value of delta will range from 0 to –1.
Call options are used by investors to speculate on an increase in the prices of an underlying stock. Conversely, when investors predict a decline in the prices, they use put options.
Delta can be used to predict the changing prices of call and put options when there is a change in the price of an underlying asset (stock).
Call options have a positive relation to the price of their underlying. It means they will generate a positive delta. Conversely, put options move in the opposite direction to the price movement of an underlying. It means put options will have a negative delta.
Options contracts’ delta behavior depends on whether the option contract is in the money, at the money, or out of the money.
For example, an in-the-money option has a delta value of +0.30, and an out-of-the-money option has a delta value of –0.70. Thus, if there is a $1 increase in the stock price, the first option will increase by $0.30 and the second will increase by $0.70.
Call options that are in the money have a closer delta to +1. Put options that are in the money have a delta closer to –1. At extreme values, a call option will reach +1 and a put option will reach –1. At these end-points, these options will exhibit a one-for-one price change relationship.
Gamma is the rate of change of delta. It measures the convexity of a derivative’s value in relation to the underlying asset’s price movement.
Delta changes continuously with the change in the price of an underlying. Thus, Gamma offers a more suitable measure to predict the price movement impact on a derivative. Delta can be used precisely in the short term; Gamma offers valuable information to investors in the long run.
Delta is a changing value that corresponds to the change in the underlying asset’s price movements. Contrarily, Gamma is a constant that measures the change in the delta. Since delta is correspondent to the price movement, the rate of change will always remain constant.
Suppose a call option with a delta of 0.35. When the stock price moves by $1, the delta changes by $0.35. Suppose after the first change, the Delta is now at 0.45. The change in delta is 0.10 which is the value of Gamma (approximately).
If two options have a similar delta but different gamma values, they will behave differently from an investor’s perspective. An option with a higher gamma will exhibit a higher risk since a price change will create a higher unfavorable impact. Conversely, an option with a lower gamma value will exhibit lower risk.
Theta measures the decline of an option contract with the passage of time. An options contract loses value as it nears the expiration date since there is less time for investors to make a profit with a change in its price.
The decrease in the value of an option contract is also called time decay. Therefore, Theta is the measure of time decay.
If all other metrics remain constant, the time decay causes a loss of value for an option. There will be less time for investors to make profits since the option’s price will not change much near the expiration date.
Theta is a risk measure for investors of call buyers. Conversely, investors who write options will prefer higher theta value because it will be cheaper for them to buy back the options contracts.
Vega is the measure of change in the price sensitivity of an option with respect to change in volatility. It represents the change in the value of an option with every 1% change in the implied volatility of an underlying asset.
Implied volatility is the evaluation of the future volatility of an underlying asset considering its current price and other factors. Since it depends on various factors and estimates, it can be different from the actual volatility of an underlying asset.
Since asset prices change with time, Vega also changes. Thus, investors need to monitor Vega continuously.
Vega increases when there is higher volatility. It means it will be greater for higher price movements. Conversely, Vega will fall when price movements are smaller, that is, when there is low volatility.
Vega is the estimation of option price changes with changing implied volatility levels. Higher volatility makes options expensive since options will have a greater risk of reaching the strike price quickly.
Long options investors benefit from increasing prices. Conversely, short options investors benefit when prices are falling. Thus, it is important for investors to keep an eye on the implied volatility, hence on Vega.
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