Option Greeks and Strategies

Derivatives_Novice_Notes_Week7: Option Greeks and Strategies

There are different ways to carry out options business, but to understand that we should learn about these key terms which would be used frequently throughout the topic.

• Intrinsic value is the difference between an options contract's strike price and an underlying asset's spot price. This value helps to determine the amount by which an option is ITM, ATM, or OTM.
• In the Money (ITM): An option is in the money if its intrinsic value is greater than zero. So, when any in-the-money option is exercised and immediately buys or sells off the underlying stock in the stock market to offset the exercise, an investor would get more profit for the selling than giving away for the buying.
• Out of the Money (OTM): OTM is the opposite of in-the-money options. When an option is out of the money, it has no intrinsic value (it can't be negative).
• At the Money (ATM): ATM is somewhere in between ITM and OTM options. They are the options whose strike price is roughly equal to the current market price of the underlying.

ITM, OTM, and ATM are measured depending on the Call and Put options.

Let us understand using a few examples.

Suppose you're looking at the Options contract for Microsoft, which is currently trading at $100 per share. Let us consider three different strike prices for both Call and Put options.

In The Money: Intrinsic value is greater than zero and generates a profit when exercised.

• Call Option: Strike Price is $95

A call option is In the Money when Spot price/current Market price ($100) is greater than Strike Price ($95); On exercising this call option; a profit of $5($100 - $95) would be made. Intrinsic value is greater than zero.

Intrinsic Value = Spot Price – Strike Price => $100 - $95 = $5

• Put Option: Strike price is $105

A put option is In the Money when the Strike Price ($105) is greater than the Spot price ($100); On exercising this put option; a profit of $5($105 - $100) would be made. Intrinsic value is greater than zero.

Intrinsic Value = Strike Price – Spot Price => $105 - $100 = $5

Out of the Money (OTM): has no intrinsic value and is not immediately profitable to exercise.

• Call Option: Strike Price is $110

A call option is OTM when the strike price ($110) is higher than the spot price ($100). If exercised this call option it won’t make a profit as the market price should be raised above $110 to have an intrinsic value.

• Put Option: Strike Price is $85

A put option is OTM when the strike price ($85) is lower than the spot price ($100). If exercised this put option it won’t make a profit.

At the Money: When intrinsic value is zero i.e. spot price = strike price.

• Call Option: Strike price = $100
• Put Option: Strike price = $100

There is no intrinsic value in both call and put options, but holds potential for both profit and loss depending on future price movements.

Option Greeks

The options Greeks are used to measure an option price's sensitivity to changes in the underlying asset.?Greeks can help an investor evaluate the risks involved in the option contracts.?

The five most important Greeks are Delta, Gamma, Theta, Vega, And Rho.

Delta

Delta measures?the rate of change between the price of the option for every $1 change in the price of the underlying asset.

Let us assume a call option has a delta of 0.6. That means a $1 change in the price of the underlying asset would cause an increase of $0.60 in the option.

Delta, in options trading, can be interpreted as the equivalent number of shares of the underlying asset. When buying a call option with a 0.30 delta, it indicates that for every $1 movement in the underlying stock, the value of the option is expected to change by an amount similar to 30 shares of the stock.

Call options have a positive delta between 0 and 1 and puts have a negative delta between 0 and -1.

Gamma

Gamma denotes the rate of change between the delta of an option per $1 change and the price of the underlying asset, thereby providing insight into the stability of an option's delta. A higher gamma indicates that even minor fluctuations in the price of the underlying asset will lead to substantial changes in the delta.

Suppose the delta of an option is 0.40. If the underlying stock moves by $1 and the option moves by $0.40 in tandem, the option's delta changes to 0.55 due to the movement. The change in delta from 0.40 to 0.55 equates to 0.15, which represents the option's Gamma.

?Theta

Theta, also known as time sensitivity or time decay, signifies the rate of change between the option price and time. Theta tells the investors how much the price of an option should decrease each day as the option approaches the expiration date, assuming all other variables remain constant. Theta is negative for options. It shows the most negative value when the option is at the money. For example, a theta value of -.04 means the option will lose $0.04 each day.

Vega

Vega measures an option's price sensitivity to changes in implied volatility, which reflects the market's expectation of future fluctuation in the price of an underlying asset. Therefore, Vega signifies the potential increase or decrease in an option's price if the implied volatility of the underlying asset rises or falls by 1 percentage point.

For instance, if an option has a vega of 0.10 and the implied volatility of the underlying asset increases by 1 percentage point, the expected increase in the option's price would be $0.10.

Rho

Rho measures the sensitivity of an option’s price to changes in the risk-free interest rate. It represents the anticipated change of a contract’s value for a 1% change in interest rates. Call options have a positive Rho, whereas put options have a negative Rho.

Option Strategies:

Option trading strategies simply refer to a combination of buying and selling various options contracts to?minimize risk and maximize returns.

In today's article, the discussion will focus on the Covered Call and Protective Put strategies.

Covered Call

The covered call strategy involves selling call options on a stock that you already own. The objective is to generate income from the premium received for selling the call options while potentially benefiting from any appreciation in the asset's price up to the strike price of the calls. A small amount of cushion may be provided by this strategy against stock price declines.

Covered call: ?Buy a stock + Sell the call Option

The risk of being long on the stock alone is reduced through a steady stream of income generated by this strategy. When an investor sells a call option, they are limiting their upside potential if the stock rises as part of the trade-off.

Below is the pay-off pattern of a Covered Call. Let us see an Example: Sam owns 100 shares of Amazon at $50 each.

Contract Details:

• Strike Price: $55.
• Option Premium: $2 per share.
• If the stock price rises above $55: Sam sells the shares at $55 but keeps the $2 premium. Sam’s effective selling price is $57 ($55 + $2).
• If the stock price stays below $55: Sam keeps the shares and the $2 premium, and the options contract will expire worthless.

Protective Put

The purpose of a protective put, also known as married put, is to hedge against potential losses in a long stock position with options. The objective is to buy a put option while maintaining a long position in the underlying stock. This strategy is akin to insurance, providing a safety net if the stock price drops.

Protective Put: Buy a stock + Buy the Put Option

The investor who enters this strategy wants the stock to trade higher but also wants protection in case the stock price falls below strike price A, giving the investor the right to sell the stock.

Below is the Payoff pattern for Protective Put.

Let us use the same example for protective puts. Sam owns 100 shares of Amazon at $50 each.

Contract Details:

• Strike Price for put option: $45
• Option Premium: $2 per share.
• If the stock price falls below $45: Sam can sell his shares at $45 using the put option, limiting his loss to $7 per share ($50 - $45 + $2 premium paid).
• If the stock price rises: Sam benefits from the stock’s appreciation, but he incurs the cost of the put premium.

To be clear, I am not a trader, and these concepts are purely based on my understanding and research of the subject. Having said that, I'll leave it at that for now. Stay tuned for next week's article on Swaps.