Option Greeks and Implied Volatility
In trading, it is best to get a good grasp of the concepts that are associated with the process of trading itself. This is because the terms mentioned below (Option Greeks and Implied Volatility) will influence the option price every time you trade. The examples and scenarios given in this article are what are known as ideal world scenarios and instances, and in actual market conditions, there will be considerable variation from the ideal world scenario!
The Greeks are a set of statistical values that offer the investor an enhanced comprehensive view of option premiums change when the changes in pricing model inputs are known. Such values can determine the options strategies that can be used. The investor should also keep in mind that statistics display trends which are based on previous performance. Also noteworthy is the fact that future stock performance isn’t guaranteed and the behavior depends on historical numbers to a large extent. Such trends often change dramatically depending on stock performance.
Delta is said to be the metric which measures the relationship between an option premium and the underlying stock price.
Gamma is the sensitivity of Delta to a one-unit change in the underlying. Gamma indicates an absolute change in Delta. For example, a Gamma of 0.150 indicates the Delta increases or decreases by 0.150 if the underlying price increases or decreases by $1.00. Results will usually not be exact.
Beta is a metric that determines the how close the movement of a particular stock tracks the movement of the whole stock market.
Theta is the metric which measures the sensitivity of an option’s premium to the fluctuation or change in time. This is said to indicate an absolute change in option value for a one-unit reduction in time until the expiration. This variable can be indicated either as a 1-day to 7-day metric. For instance, a Theta of -.035 shows the option’s theoretical value changes by -.035 if the number of days reduces by seven. The results obtained herein may not be exact values due to rounding off. One also has to remember that a 7-day Theta will change right to one day Theta if the days to expiration are seven or less, and this is known as Time decay.
Rho is the metric which measures the sensitivity of option value to the fluctuation in an interest rate. It shows the absolute change in option value for a 1% fluctuation in the interest rate. For instance, a Rho of .070 shows the option’s theoretical value rises by 0.070 if the interest rate reduces by 1.0. The results are not expected to be of exact values due to the rounding off of the values.
Vega is said to be the metric that measures the sensitivity of option value with regard to changes or fluctuations in the implied volatility. Vega is said to indicate the absolute change in option value for a 1% change in volatility. For instance, a Vega value of 0.080 shows the options theoretical magnitude raises by 0.080 if the implied volatility rises by 1.0%. Similarly, the option’s theoretical value decreases by 0.080 when the implied volatility dips by 1.0%.
The Black-Scholes Formula
This formula was the first broadly used model to calculate option pricing. Strategists use this formula to compute the theoretical value for a particular option utilizing current stock prices, the options strike price, expected dividends, time to expiration, expected interest rates and also the expected market volatility.
Even though this model does not ideally explain real world options, it is still frequently applied to the trading and valuation of options.
Variables of the Black-Scholes formula are:
• Time left until expiration is expressed as per annum percentage
• Stock Price- This is the last transaction price of an underlying option. It is also the last price a share of stock was bought or sold for in the market.
• Volatility metered by the annual standard deviation
• Strike Price- is the price at which the holder of an option can carry out the contract.
• Existing risk-free interest rate
Volatility is of paramount importance when it comes to choosing from the options that exist to sell or buy. As the b name suggests, historical volatility shows the spectrum of fluctuation that a given stock’s price undergoes within a given time period. The mathematical value of volatility can be defined as the standard deviation of a stock’s daily price calculated over a year.
Two kinds of volatility have been defined:
Statistical or Historical volatility is defined as the actual price fluctuations observed over a specified time period.
Implied Volatility is the metric which defines the amount by which the market place anticipates the asset price is predicted to change for a given option price. Simply put, it is the volatility implied by the market.
While it isn’t easy to calculate volatility mathematically, strategists can allow the market itself to calculate the volatility using implied volatility. This is analogous to the effective market hypothesis that, if there is sufficient trading interest in an option which is near to at-the-money, then that option is said to be priced reasonably.