What are the Option Greeks - PowerPoint PPT Presentation

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What are the Option Greeks

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If you’re somewhat new to Options, you must have heard about the Option Greeks. In fact, a common rookie mistake with Options traders is that they ignore the Greeks. In this post, hopefully, I can convey the importance of Option Greeks explained in simple terms. This is easily one of the biggest mistakes a newbie Options trader can do. – PowerPoint PPT presentation

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Title: What are the Option Greeks


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  • What are the Option Greeks
  • Option Greeks explained
  • Author Hari Swaminathan

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(No Transcript)
3
About OptionTiger
  • If youre somewhat new to Options, you must have
    heard about the Option Greeks. In fact, a common
    rookie mistake with Options traders is that they
    ignore the Greeks. In this post, hopefully, I can
    convey the importance of Option Greeks
    explained in simple terms. This is easily one of
    the biggest mistakes a newbie Options trader can
    do. 
  •  
  • Youll find the Option Greeks explained in many
    complicated ways youll find common
    explanations for Delta as the amount an Option
    price will change for a 1 move in the
    underlying, and youll find similar explanations
    for the other 3 main Greeks as well Gamma,
    Theta and Vega. Let me try a slightly different
    explanation here.
  •  
  • You are an airline pilot
  • Put yourself in the shoes of an airline pilot. A
    pilot needs two sets of tools to fly the plane
    safely from Point A to Point B. 
  • 1) The pilot needs a map to know where to go.
  • 2) The pilot also needs a set of reliable
    instruments to get from A to B.

4
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  • In the Options world, the map is the Profit
    Loss diagrams, and various Options simulation
    tools you have including the simulation of risk
    graphs. You look at the risk graph and you get a
    visual idea of where you need to go. You tweak
    the simulation parameters to know how your
    position will perform under different market
    conditions like Price movement, changes in
    Volatility or with the passage of time. You can
    tweak one or all of these parameters and you can
    see how these simulations impacts your Risk
    Graph. This is the Map. Its visual. And you get
    a clear visual idea of how to navigate your trade
    by mentally setting various adjustments, and even
    the nature of adjustments. 
  • The second tool is a reliable set of instruments
    that can get the plane from A to B. In the
    Options world, this set of instruments are your
    Option Greeks. Think of the four main Greeks as
    the set of four key instruments available to you
    as the pilot of your Options trade. If one of
    these instruments has overshot some
    pre-determined limits, you have to turn its knob
    to one side to bring it back into the acceptable
    limits. You do this for all four Greeks in an
    effective manner, and youre actually guiding
    your plane safely to your destination. This
    analogy is very true You can control every
    aspect of your Option position simply by tweaking
    the four Greeks. You dont even need to look at
    what the markets or your stock is doing. You can
    manage your adjustment points, and once you
    become an expert, you can navigate your Options
    plane on auto-pilot. Hopefully, you have a
    better appreciation for how important Option
    Greeks are. 
  •  

5
About OptionTiger
  • But what exactly are the Option Greeks ? What do
    they measure ? And why is it the case that these
    obscure terms can have such control on whats
    going on in the markets ?
  •  
  • The key lies in the fundamental facts about what
    Options are, and how the Black Scholes Options
    pricing model was invented.  Youve probably
    heard before that Options are a mathematical
    concept. Buyers and sellers barter rights and
    obligations. There is no underlying security that
    is actually traded, you only trade contracts with
    rights and obligations that are based on an
    underlying security like shares of a stock. All
    Options also have an expiry date of some time in
    the future. Options do cost money, so there is a
    cost of carry of these rights and obligations.
    The opportunity cost of this capital is dependent
    on the prevailing interest rate environment. And
    because Options have an expiry date, they must
    lose some value as time passes. And once again,
    because of this expiry date, you have to ask this
    question Within a certain amount of time, what
    is the probability of a certain stock reaching a
    certain price (strike price of the option). To
    answer this question on probability, you need to
    know the Volatility of the stock, with
    Volatility being defined in standard deviation
    terms based on that stocks historical stock
    prices (say past 12 months).

6
About OptionTiger
  • So pricing an Option has to consider all these
    elements. The inventors of the Black-Scholes
    formula had to consider all these elements.
    (Notice I used the word formula in this
    sentence). And this is the key. Everything in
    Options pricing is a formula. The way an Option
    responds to price movement of the underlying
    stock is a formula. The way it responds to
    passage of time is a formula. The way it responds
    to changes in Volatility is also a formula and so
    on and so forth with interest rates, cost of
    capital etc. So everything is a formula. Options
    are a truly mathematical concept, and the price
    of an Option has many components to it, and each
    of its components responds to one or more of
    these parameters. 
  •  
  • In the case of response to changes in the
    underlying price of the stock the Greeks are
    Delta and Gamma
  • Sensitivity to the passage of time is measured
    by the Greek Theta.
  • Sensitivity to changes in Implied Volatility is
    measured by Vega. 
  •  
  • Interest rates is Rho..and so on.

7
About OptionTiger
  • And each one of these Greeks are calculated by a
    formula from the Black Scholes model. Because of
    this fact, we can manage the entire options
    position simply by managing the Greeks. Imagine
    yourself looking down upon an instrument panel
    with these four main instruments. And in front of
    you is the market, but youre not looking at the
    market because youre looking down at your
    instrument panel which is getting a real-time
    feed of whats going on in the markets, by way of
    changing Option prices. The Greeks are changing
    because of the change in Option prices, and all
    youre doing is managing your Greeks, and
    navigating your trade to success. You can be
    oblivious of everything else. Thats how
    powerful Option Greeks are.

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