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ADVANCED OPTION

GREEKS
Black Scholes Model ReCALL Option
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Black Scholes Model - R
There are many packages available for option
pricing in R. We will be using fOptions
install.packages(fOptions)
library(fOptions)
Black Scholes Model - R
Trading Option Greeks
Option can be used to take a bullish or bearish
position, given a directional forecast
We can trade sideways nontrending stocks or volatile
stocks as well
Profit or loss can be independent of whether stock rises or
falls
Option trading is non-linear. Hence, more
opportunities can be exploited by trading options
than trading stock
Option Trader
Option can be used to take a bullish or bearish
position, given a directional forecast
We can trade sideways nontrending stocks or volatile
stocks as well
Profit or loss can be independent of whether stock rises or
falls
Option trading is non-linear. Hence, more
opportunities can be exploited by trading options
than trading stock
GREEKS
Greeks
The greeks are a product of option pricing model
and each greek letter represents a specific sensitivity
to influences on the options value
The five greeks commonly used by traders are,
Delta
Gamma
Theta
Vega
Rho
Delta () Formula
Formula for delta of call option is given by,
Delta of put option can be obtained using put-call
parity
Delta ()
Delta is the rate of change of an option value
relative to a change in the underlying stock price
Delta Call Option
Delta for a call option has positive correlation with the
stock price. Therefore delta for call option is positive.
If a bullish trader buys a call instead of stock, he expects
the call option price to go up, but by how much? To
answer that question consider the delta of the option
Delta is stated as a percentage.
Delta gives us an approximate change in price of option
w.r.t. underlying in case of small changes. As the change in
underlying increases, error in approximation will increase.
Delta Call Option
S=60, X=60, r=0.04, t=26/365, sigma=0.3
Call Option Price = 1.91
Delta of Option = 0.514
S=61, X=60, r=0.04, t=26/365, sigma=0.3
Call Option Price = 2.47 ~ 1.91+0.514
S=59, X=60, r=0.04, t=26/365, sigma=0.3
Call Option Price = 1.44 ~ 1.91 - 0.514
Delta Put Option
Price of put option will increase with decrease in stock
price. So put option value has negative correlation
with stock price.
Delta of a put option will be negative. It will vary
between range of 0 and -1.
Delta Definition 2
Delta can be thought of as owning that many number
of underlying shares
So options gives us a way to leverage
E.g. S=60, X=60, r=0.04, t=26/365, sigma=0.3
Call Option Price = 1.91
Delta of Option = 0.514
Here you own 0.514 shares for just 1.91 instead of
60*0.514~30.84
Delta Definition 3
Delta is also known as hedge ratio
As we had seen in case of binomial pricing model.
We can construct a self financing portfolio with delta
number of shares. Market makers use delta as hedge
ratio to hedge themselves.
Delta Definition 4
Traders would say that delta is a statistical
approximation of the likelihood of option expiring in
the money.
This definition is mathematically imprecise but is used
nonetheless as general rule of thumb by option
traders.
Deltas of Call and Put of same strike
Strike Call Delta Put Delta
50 0.99 -0.01
55 0.87 -0.13
60 0.51 -0.48
65 0.17 -0.83
70 0.03 -0.97
Because of put-call parity we get sum of absolute value of
same strike call and put as 1.
Dynamic Inputs
Option Deltas are NOT constant.
They are calculated from the dynamic inputs of the
pricing model stock price, time to expiration,
volatility and so on.
When these variables change, the changes affect the
delta.
Instead of learning underlying math, we will consider
the effects from a more qualitative perspective.
Delta and Moneyness
Delta and Moneyness
Just by looking at delta you can tell the moneyness of
the option
Far out of the money options have delta close to
zero
Deep in the money call options have delta close to
+1
Deep in the money put options have delta close to
-1
At the money options have delta about 0.5 (or -0.5
for puts)
Effect of Time on Delta
The more time left untill option expiry, the less certain
it is whether the option will be ITM or OTM at
expiration.
The deltas of both the ITM and OTM option reflect
that uncertainty.
The more time left in the life of option, the closer the
deltas gravitate around 0.5.
Effect of Time on Delta (Call)
Effect of Time on Delta (Put)
Call Delta vs. Time to Expiration
Put Delta vs. Time to Expiration
Effect of Volatility on Delta
For In the Money options higher the volatility then
higher the chances that it will end less ITM or OTM
(keeping all other parameters constant).
Similarly, for OTM higher the volatility, more will be
the chance for the option to expire in the money.
Hence for OTM options, higher volatility option will
have higher deltas compared to lower volatility and
same time to expiry.
Effect of Volatility on Delta (Call)
Effect of Volatility on Delta (Put)
Call Delta vs. Volatility (Call)
Call Delta vs. Volatility (Put)
Gamma ()
The strike price is the only constant in the pricing model.
When the stock price moves relative to the constant, the
option in question becomes more in-the-money or out-of-
the-money. This means delta changes.
This isolated change is measured by options Gamma,
sometime called as curvature.
Gamma () is the rate of change of an options delta
given a change in the price of underlying security.
Gamma is conventionally stated in terms of deltas per
one point change in underlying.
Gamma () Formula
Gamma ()
Gamma () Example (Call)
Example 1
Example 2
Gamma () Example (Put)
Example 1
Example 2
Gamma () Explained
When traders buy options, they acquire positive gamma.
Since gamma causes options to gain value at a faster rate
and lose value at a slower rate, gamma helps the option
buyer.
When traders sell options, gamma works against them.
The delta value moves toward zero at slower rate. When
the underlying moves adversely, gamma speeds up losses.
The effect of gamma is less significant for small moves in
the underlying than it is for bigger moves.
Gamma () Definition 2
Gamma is the second derivative of the graph of the
option price relative to stock price.
Put another way, gamma is the first derivative of the
graph of delta relative to stock price(s shaped curve)
So not only delta changes, it changes at a changing
rate.
Gamma is not constant. Moneyness, time to expiration
and volatility each have an effect on the gamma of
the option.
Gamma and Moneyness
Gamma and Moneyness
When options are far in-the-money or out-of-the-
money, they are either at 1 delta or 0 delta,
respectively.
At the extremes, small changes in the stock price will
not cause the delta to change much.
When option is at the money, its delta changes very
quickly.
Summary,
ITM and OTM options have low gamma
ATM options have relatively high gamma
Gamma vs. Time to Expiry
A decrease in the time to expiration solidifies the
likelihood of ITMs or OTMs remaining as such. But an
ATM options moneyness at expiration remains to the very
end uncertain.
As expiration draws nearer, the gamma decreases for ITMs
and OTMs, and increases for the ATM strike.
Gamma vs. Time to Expiry
Gamma vs. Time to Expiry
Gamma vs. Volatility
An increase in the volatility will increase chances of
ITM to expire out of money and OTM to expire in the
money. Hence gamma for ITMs and OTMs will increase with
increase in volatility and vice versa
As volatility increases gamma for ATMs decreases.
Gamma vs. Volatility
Gamma vs. Volatility
Gamma vs. Volatility
Gamma Summary
Short-term ATM options with low volatility have the
highest gamma.
Lower gamma is found in ATMs when volatility is
higher and it is lower for ITMs and OTMs and in
longer-dated options.
Theta ()
Option price can be broken down into two
components,
Intrinsic Value (ITM part of the premium)
Time Value (leftover)
All else held constant, the more the time left in the life
of the option, the more valuable it is (there is more
time for the stock to move).
And as the useful life of an option decreases, so does
its time value.
Theta ()
The decline in the value of an option because of
passage of time is called time decay, or erosion.
Theta is the rate of change in an options price given
a unit change in the time to expiration.
What is unit change in time?
One days worth of time decay
Seven Days or Business Days week
Seven days worth of time decay
We will use one days worth of time decay based on
seven days week
Theta ()
Commonly after afternoon, option price can often be
observed getting cheaper relative to the stock price.
This is because traders will normally take a day out
of their model once prices are stabilized.
On Fridays and sometimes late Thursdays, traders will
take all or part of the weekend out. Commonly by
Friday afternoon traders will be using Mondays days
to value their options.
Is Theta () good or bad?
Theta can be good or bad depending on the position
Theta hurts long positions; whereas it helps short
option positions.
E.g. The 32 day 80 call has a theta of 0.03. If trader
is long this call, the traders position would lose 0.03,
as the time until expiration changes from 32 to 31.
A higher theta for the call than for the put of the
same strike price is common when interest rate is
greater than zero is used in the pricing model (We
will see this later).
Theta vs. Moneyness
Theta vs. Moneyness
The more the ITM an option gets, the higher its
theoretical value. But when studying an options time
decay, one needs to be concerned only with the
options time value, because intrinsic value is not
subject to time decay.
The ATM option have more time value than ITMs or
OTMs option. Hence they have more time premium to
lose in the same period.
Effect of time on Theta
As the number of days to expiration decreases, the
rate at which an option decays may change,
depending on the relationship of the stock price to
the strike price.
ATM options tend to decay at non-linear rate,
whereas the time values of ITM and OTM option
decay at a steady rate.
Effect of time on Theta
Effect of volatility on Theta
The volatility input to the pricing model has a direct
relationship to the option values.
The higher the volatility, the higher the value of the
option.
Higher valued option decay at faster rate.
All else held constant, the higher the volatility
assumption, the higher the theta.
Vega
The volatility component of options value is called
implied volatility. The higher the volatility input, the
higher the theoretical option value, holding all other
variables constant.
Vega is the rate of change of options value relative
to a change in value of implied volatility.
Specifically if the implied volatility rises or declines
by one percentage point, the value of the option rises
or declines by amount of the options vega.
Vega
Buying a call or put establishes a long vega position
An increase in IV and subsequent increase in options
value helps the P&L of long option positions and hurts
short option positions
A put with same expiration month and same strike on
same underlying will have the same vega value as its
corresponding call.
Vega is also referred as Kappa sometimes.
Vega vs. Moneyness
Implied Volatility affects only time value portion of an
option.
Because ATM options have the greatest amount of
time value, they will have higher vegas.
ITM and OTM options have lower vega values than
those of ATM options
Volatility vs. Call Price
X = 60
Sigma = 0.3
Vega vs. Moneyness
X = 60
Sigma = 0.3
Effect of Implied Volatility on Vega
Effect of Implied Volatility on Vega
Effect of Implied Volatility (IV) on Vega
At all IV ATM strike option maintains a similar vega
value. This makes it easy to estimate the theoretical
value of an at-the-money option under a wide variety
of volatility scenarios.
Lower IV inputs tend to cause ITM and OTM vegas to
decline. Higher IV inputs tend to cause vegas to
increase for ITM and OTM options.
Effect of Time to Expiry on Vega
Effect of Time to Expiry on Vega
Vega of all options declines as expiration
approaches.
Therefore, a long-term option will always be more
sensitive to a change in volatility than a short term
option with otherwise identical contract specification.
Interconnection of Time and Volatility
More time to expiration means more time for volatility
to take effect, while less time to expiration may mean
that any change in volatility will have only a minor
effect on an options value.
Moreover, changes in the amount of time remaining to
expiration and changes in volatility often have similar
effect on an options value.
Decreasing volatility is similar to decreasing time to
expiration.
Rho
Sensitivity of an options theoretical value to a change
in interest rate is given by its rho.
Unlike the other sensitivities, one can not generalize
about the rho since its characteristics depend on the
type of underlying instrument and the settlement
procedure.
The interest rate is usually the least important of the
inputs into a pricing model. For this reason, rho usually
takes a backseat to other sensitivities.
Rho Summary
In all cases the option which have the highest rho are
those which are deeply-in-the-money, because they
require greatest cash outlay.
And the greater the amount of time to expiration, the
greater the rho.
Greeks Sign Summary
Greeks Effect of changing market conditions
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