Greeks and Implied Volatility
Greeks help you anticipate changes in option price compared to change in the stock price
Delta:
A ratio that compares the price change of an option with the price change of the stock
Ranges from 0.00 to 1.0
A delta of 1 means that for every dollar the stock rises or falls, the option will also rise and fall one dollar
A delta of of .50 woulf mean that for every dollar the stock rises or falls, the option rises or falls 50 cents
Out of the money strike prices deltas range between .5 and .75
The farther In the money an option becomes, the higher the delta climbs
Gamma:
A ratio that compares the rate of change of DELTA with the rate of change of the stock
Gamma shows how DELTA rises and falls as the stock rises and falls
Gamma=.10 means that for ever dollar the stock moves, DELTA will move by .10
Theta:
Theta compares the rate of TIME DECAY with the passing of each calande day.
Theta= .05 means that the option will lose time value at a rate of .05/share or $5.00 per contract per day
Theta will increase and Time Value will erode more quickly as exp date approaches
there are factors which affect time decay such as volatility
Vega:
Vega estimates how much the theoretical value will change when volatility changes by 1%
High volatility means higher options prices
Low volatility= lower options prices
+VEGA means the value of the option position will increase when the volatility increases and the value of the option position will decrease when the volatility decreases
-VEGA means that the value of the option position will decrease when volatility increases and increase when the volatility decreases
Example: A vega of +.03 and volatility of 20% has a value of 5.00.
(This is a call)
If the volatility rises to 21%, the call will be worth 5.30
If the volatility falls to 195, The call will be worth 4.70
19%
Rho:
Estimates how much the theoretical value will change when interest rates change 1%
RHO is rarely used
Long calls and short puts have +RHO
Short calls and long puts have -RHO
An increase in interest rates increases the values of calls and decreases the value of puts
A decrease of interest rates decreases the values of calls and increases the value of Example:
A call with a RHO of +.05 is worth 5.00 when the interest rate is 5%
If Interest rates rise to 6%, the call would be worth 5.05
Implied Volatility:
Indicates how much the stock is expected to move during the life of the option
This number is almost always higher than historical volatility, because the future is not certain
You should view an option as overvalued if the option's implied volatility is greater than it's historical volatility
If the options current implied volatility is lower than its historic volatility, the stock is undervalued
In theory anyway
In real life, determining whether an option is under or overvalued is quite difficult because implied volatility changes from day to day
sometimes violently
: News, earnings and other factors cause the implied volatility rates to rise sharply because there is s greater chance the stock may move very high or low quickly
Implied volatility can also drop as quickly as it climbs.
Comparing current implied volatility to past implied volatility is better than comparing current implied volatility to Historical volatility
High Implied Volatility means the MM's expect the stock to move alot in the future
If implied volatility is 31%, that means the stock must move 31% to make a profit
Greeks and Spread Positions
If net Delta is +, you want the underlying to rise.
If net Delta is -, you want the underlying to fall.
If net gamma is +, you want the underlying to move rapidly, up or down.
If net gamma is -, you want the underlying to move slowly, up or down.
If net Theta is +, time decay benefits you.
If net Theta is -, time decay hurts you.
If net Vega is +, you want volatility to rise.
If net Vega is -, you want volatility to fall.
Implied Volatility and Spreads
Note:Vertical spreads are usually not as sensitive to volatility spreads as the spreads listed below.
If implied volatility is low and expected to rise, spreads with a net + vega will benefit.
1. Long Straddles and strangles
2. Long calendar and diagonal spreads
3. Short Butterfly spreads
4. Ratio Backspreads
If implied volatility is high and is expected to fall, spreads with a net - Vega will benefit.
1. Short straddles and strangles
2. Long butterfly spreads
3. Short Calendar and diagonal spreads
4. Ratio Vertical Spreads-
