OPTIONS

Friday, November 20, 2009

Relationship between OPTIONS GREEK with DEGREE of MONEYNESS, IMPLIED VOLATILITY and TIME TO EXPIRATION: Summary – Part 1

Option Greeks have been one of the main topics that I have previously shared in details in this blog.
I’ve tried to explain each of option greek in a simple way for easy but yet deep understanding. It’s really not easy doing this, but I was very encouraged by many compliments and positive feedback from my readers. I'm happy that many people in fact have benefited from these Option Greeks articles. I'd really like to thank my readers for their continuous support. :)
Here I tried to summarize the main understanding of Options Greeks:

DELTA
Delta is an option greek that measures of the change in the option price due to a change in the underlying stock price.

Delta of ATM, ITM & OTM Options
The delta values for long position will be positive for Calls (0 to 1) & negative for Puts (0 to -1).
At-the-money (ATM) options have deltas around 0.5 (Calls: +0.5, Puts: -0.5).
Out-of-the-money (OTM) options have deltas between 0 to 0.5 (Calls: 0 to +0.5, Puts: 0 to -0.5).
In-the-money (OTM) options have deltas between 0.5 to 1 (Calls: +0.5 to +1, Puts: -0.5 to -1).

Effect of Time To Expiration on Delta:
As the time to expiration is nearing, the delta of ITM options increases (i.e. ITM option’s delta gets closer to 1 for Calls or to -1 for Puts) and the delta of OTM options decreases (i.e. OTM option’s delta gets closer to 0).

Impact of Implied Volatility on Delta:
When Implied Volatility (IV) increases, delta of OTM option will increase, whereas the delta of ITM option will decrease.
However, the delta of ATM option will always remain at around 0.5.

GAMMA
Gamma is an options greek that measures the rate of change of delta due to a one-point change in the price of the underlying stock.
In other words, Gamma estimates how much delta would change if the price of the underlying stock changes by $1.
So, gamma indicates how “stable” its corresponding delta is.
A high gamma means that the delta can change considerably for even a small move in the stock price.
Unlike delta, gamma for long position is always positive for both Calls and Puts. That means delta will increase as the underlying price increases, and delta will decrease as the underlying price decreases.

Gamma of ATM, ITM & OTM Options
Gamma is the largest for ATM options, and gradually decreases as it moves furthers towards ITM and OTM.
This means that the delta of ATM options changes the most when the stock price moves up or down, as compared to ITM & OTM options.

Effect of Time To Expiration on Gamma
As the time to expiration gets nearer, the gamma of ATM options increases (is relatively higher), whereas the gamma of deep ITM and deep OTM options normally decreases (is relatively lower).

Impact of Implied Volatility (IV) on Gamma
When the Implied Volatility decreases, the gamma of ATM options increases, whereas the gamma for deep ITM or OTM options decreases.
When the Implied Volatility is very low, the gamma of ATM options is relatively high, while the gamma for deep ITM / OTM options is relatively low (close to 0).
This is because when the volatility is low, the time value portion of an option is low. However, time value of ATM option is still higher relative to ITM & OTM options, hence the gamma of ATM option is higher as compared to ITM & OTM options.

On the other hand, when IV is high, gamma tends to be stable for ATM option as well as ITM and OTM options. This is because when volatility is high, the time value of deep ITM / OTM options are already quite substantial. As a result, the increase in the time value of deep ITM / OTM options as they go nearer the money will be less dramatic. Therefore, gamma tends to be stable across all strike prices in this case.

Continue to Part 2.

Related Posts:
* Free Trading Educational Video: Learn Technical Tips from Dan Gramza
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Understanding Implied Volatility (IV)
* Understanding Option’s Time Value
* Learning / Understanding Candlestick Charts
* Learning Charts Patterns

0 comments: