Options are derivatives based on the value of underlying securities (such as stocks). Option contracts provide buyers with the opportunity to buy or sell underlying assets, depending on the type of contract they hold.
Unlike futures, if the holder chooses not to buy or sell the asset, there is no need to buy or sell the asset. Call options allow the holder to purchase assets at a specified price within a specific time.
Put options allow the holder to sell assets at a specified price within a specific time. Each option contract has a specific expiration date, and the holder must exercise his option before that date.
The specified price of an option is called the strike price. Options are usually bought and sold through online or retail brokers.
Understanding Options
Option is a multifunctional financial product. These contracts involve buyers and sellers, where the buyer pays premiums for the rights granted by the contract. Every call option has a call buyer and a put seller, while a put option has a put buyer and a call seller.
Option contracts usually represent 100 shares of the underlying security, and the buyer will pay a premium for each contract. For example, if the premium for an option is 35 cents per contract, the cost of purchasing an option is $35 ($0.35 x 100 = $35).
The premium is partly based on the strike price, which is the price at which the security is purchased or sold before the expiry date. Another factor of the premium is the expiration date. Like the carton of milk in the refrigerator, the expiration date indicates the date on which the option contract must be used. The underlying asset will determine the date of use. For stocks, it is usually the third Friday of the contract month.
Traders and investors will buy and sell options for a variety of reasons. Option speculation allows traders to hold leveraged positions in assets at a lower cost than buying a share of the asset. Investors will use options to hedge or reduce the risk exposure of their portfolio.
In some cases, option holders can generate income when they purchase call options or become option writers. Option is also one of the most direct ways of oil investment. For option traders, the daily trading volume of options and open positions are two key figures that need to be paid attention to make the most sensible investment decisions.
American options can be exercised at any time before the expiry date of the option, while European options can only be exercised on the expiry date or exercise date. Exercising means taking advantage of the right to buy or sell the underlying securities.
Options Risk Metrics: The Greeks
“Greek” is a term in the options market used to describe the different dimensions of risk involved in holding an option position in a particular option or combination of options. These variables are called Greek variables because they are usually associated with Greek symbols.
Each risk variable is the result of an incorrect assumption or the relationship between the option and another underlying variable. Traders use different Greek values (such as delta, theta, etc.) to assess option risk and manage option portfolios.
Delta
The delta (Δ) represents the rate of change between the option price and the $1 change in the price of the underlying asset. In other words, the price sensitivity of the option relative to the underlying security.
The spread of call options ranges from zero to one, while the spread of put options ranges from zero to minus one. For example, suppose that the call option for an investor’s long call option is 0.50.
Therefore, if the price of the underlying stock rises by $1, the price of the option will theoretically rise by 50 cents. For option traders, delta also represents the hedge ratio used to create delta-neutral positions.
For example, if you bought a standard US call option (with an option yield of 0.40), you would need to sell 40 shares to fully hedge. The net increase in the option portfolio can also be used to obtain the hedging of the portfolio.
A less common use of option spread is the possibility that it will currently expire in the money. For example, today there is a 0.40 incremental call option with an implicit 40% possibility of completion in the currency.
Theta
Theta (Θ) represents the rate of change between option price and time, or time sensitivity-sometimes called the time decay of an option. Theta said that the price of an option will decrease as the expiration time decreases, and all other conditions are the same.
For example, suppose an investor holds an option with a theta of -0.50 for a long time. With all other conditions unchanged, the price of the option falls by 50 cents a day. If three trading days pass, the value of the option will theoretically decrease by $1.50.
When the option price is reasonable, Theta will increase, and when the option currency is inside or outside, Theta will decrease. Options approaching the expiration date will also accelerate time decay.
Long call options and long put options usually have a negative Theta; short call options and short put options will have a positive Theta. In contrast, tools whose value does not erode over time (such as stocks) have zero Theta.
Gamma
Gamma (Γ) represents the rate of change between the increment of the option and the price of the underlying asset. This is called the second-order (second derivative) price sensitivity. Gamma represents the amount of incremental change after the underlying security changes by one dollar.
For example, suppose the investor is a long call option on the hypothetical stock XYZ. The spread of the call option is 0.50, and the gamma value is 0.10. Therefore, if stock XYZ increases or decreases by $1, the spread of the call option will increase or decrease by 0.10.
The gamma value is used to determine the stability of the option increment: a higher gamma value indicates that even a small change in the price of the underlying security may cause a huge change in the increment. In-the-money and out-of-the-money, and accelerate as the expiration date approaches.
The farther away from the expiration date, the smaller the Gamma value is usually; options with a longer expiration time are less sensitive to incremental changes.
As the expiration date approaches, the gamma value will usually be larger, because price changes will have a greater impact on the gamma. Option traders may choose not only hedging, but also hedging to maintain a neutral spread, which means that as the underlying price fluctuates, the spread will remain close to zero.
Vega
Vega (Vega) represents the rate of change between the value of the option and the implied volatility of the underlying asset. This is the sensitivity of options to volatility.
Vega represents the amount of change in the price of an option when the implied volatility changes by 1%. For example, an option with a Vega of 0.10 indicates that if the implied volatility changes by 1%, the value of the option is expected to change by 10 cents.
Since an increase in volatility means that the underlying instrument is more likely to experience extreme values, an increase in volatility will increase the value of the option accordingly. Conversely, a decrease in volatility will negatively affect the value of options. For at-the-money options with longer expiration times, Vega has played its biggest role.
Rho
Rho (p) represents the rate of change between the option value and the 1% change in interest rate.
This measures the sensitivity to interest rates. For example, suppose the call option has a rho value of 0.05 and a price of $1.25. If the interest rate rises by 1%, the value of the call option will rise to $1.30, all other conditions are the same. Put options are the opposite. Rho is the most suitable option for at-the-money options, long-term until expiration.
Minor Greeks
Some other Greeks that are rarely discussed are lambda, epsilon, vomma, vera, speed, zomma, color, and ultima. These Greeks are the second or third derivative of the pricing model, which will affect issues such as delta changes and volatility changes.
They are increasingly used in options trading strategies because computer software can quickly calculate and resolve these complex and sometimes esoteric risk factors.
