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In the previous post, we discussed the Option Greeks and got a perspective on what they are. An understanding of the previous article is important for this article. In this article we will attempt to help you understand the practical uses of Option Greeks, and how you can use the Greeks to trade options more profitably.
Option Greeks are also called the option sensitivities, as each of the Greek is sensitive to a particular market variable. Sensitivity represents risk in some form or the other. When you have an open option position, the intensity of these sensitivities have a magnifying effect simply because they exert their influence on the option position ‘simultaneously’. Think about it.
- No one can stop time hence, theta has a continuous effect
- No one can stop the markets from its natural movement, hence the delta is on the move always
- Market participants are always driven by emotions, which translates to market volatility, hence the vega gyrates all the time
To give you perspective, imagine a juggler, trying to juggle 5 different balls while standing at the edge of a mountain cliff. This is what happens, when you trade options! The 5 different balls are equivalent to the Greeks, and the cliff itself is the markets!
As we know, the delta helps the trader understand the rate at which the option premium is likely to change based on a change in the underlying price. Hence delta is highly sensitive to the price change in the underlying. Any naked option position has a non zero (for all practical purpose) delta value.
Before we proceed, let us revisit some basics. We know the delta varies between 0 and 1 for a call option, and -1 to 0 for a put option. For the sake of simplicity, let’s consider the call option delta to vary between 0 and 100, and put option delta to vary between -100 to 0.
Also, the delta of futures is always 100. This is because the future always move (magnitude and direction) in line with the underlying. So, the delta of futures contracts (Nifty Futures, Infy futures, ACC futures etc) is always 100.
Keeping this in perspective, imagine the following situation.
A trader is long 3 lots of Nifty 7800 CE while the spot is trading at 7700. Clearly, the option is OTM(out of the money), hence the delta should be less than 50. Let us assume the delta as 40. The intention is to hold the option position open for 2 weeks. However, after initiating the long call position, the trader is now worried about a potential selloff in markets (maybe over the next two days), hence would like to hedge the open option position.
The trader can hedge the position by calculating a simple ratio called the ‘Hedge Ratio’. The hedge ratio helps determine the number of futures lots one needs to short in order to be hedged against the anticipated fall in the market.
The hedge ratio is simply the ratio of the option delta to the futures delta. Remember, the futures delta is always 100.
Hence, going back to the example, the delta of the option is 40 and futures is 100; hence the hedge ratio would be:
This means to hedge 1 option position with 40 delta, the trader need to short 0.4 lots of futures. Since there are 3 lots of option, it would be 0.4 x 3 = 1.2 lots. Obviously one cannot short 1.2 lots, hence the closest approximation would be 1 lot of futures short.
The trader now has 3 lots of 7800 CE long, and 1 short futures position. Think about this in terms of ‘total position delta’.
Without the hedge the trader had 3 lots of Call options with total position delta of 120. In other words, a delta of 120 indicates that for every 1 point move in underlying, the option premium varies by 1.2 points. By adding the short futures position, the trader has now neutralized the delta by 100 points, leaving a total delta exposure of 20.
Imagine that it was possible to short 1.2 lots of futures, in which case the short futures would contribute to -120 delta, which would completely neutralize the long option’s 120 delta. The combined position (3 lots of CE , and 1 lot of short futures) yield 0 delta [120 delta from call option minus 120 delta from futures].
When you have a zero delta position, it is also called a ‘Delta Neutral’ position. When we have a delta neutral position, the total delta of the combined positions is 0. This means for every 1 point change in the underlying, the position moves by 0 points.
A delta neutral position indicates that the option position’s sensitivity to directional risk is completely taken away. When one establishes a delta neutral position, the direction does not matter – the market can go up or down but the position will not get affected. In other words, the direction no longer matters!
Classic delta neutral strategies include the straddles and the strangles.
In a straddle strategy, you buy both ATM(at the money) call and put option expiring at the same time. Consider this example…
Spot Nifty = 7780
Call Strike = 7800
Put Strike = 7800
Both the options are ATM, hence their approximate delta would be:
Call Delta = + 50
Put Delta = -50
Total position delta = +50 – 50 = 0, making it delta neutral.
So irrespective of how many positions you have, always add up the delta to know your position’s sensitivity to direction. Keep the following two points in mind..
- If the delta add up to 0, then you have a delta neutral position. This means you are completely insulated to any directional risk
- If the delta add up to 100 (for example buying 2 ATM Nifty call option yields a combined delta of 100) this is as good as owning a Nifty futures, since nifty futures has a delta of 100
If you aspire to be a full time options trader, I would suggest you internalize the concept of delta quite well as it forms the foundation for interesting strategies such as –‘Volatility arbitrage using dynamic delta hedging’.
Traders usually underestimate the effect of vega, and the massive influence it has on an options position. Understanding vega and its implication on an option position is one of the keys to successful options trading. In the previous article, we stated that the options premium (both call, and put) increases with increase in volatility. Let us explore this a bit deeper.
The chart below shows the behavior of a call option premium with regards to increasing volatility, when there are
- 5 days to expiry (red line)
- 15 days to expiry (green line)
- 30 days to expiry (blue line)
The graph below shows what would happen to the options premium, if volatility were to increase when there are 5 days to expiry.
As you can see, irrespective of how many days are left to expiry, the option premium always increases with respect to increase in volatility. However, on a closer observation there are few other things that come to light. When volatility increased from 15% to 30%:
- The call option premium changed to 58 from 37 (54%) when there were just 5 days to expiry
- The call option premium changed to 127 from 69 (84% ) when there were 15 days to expiry
- The call option premium changed to 190 from 96 (97%) when there were 30 days to expiry
Similar observation can be made for put options.
We can generalize two things:
- Premium always increases when the volatility increases
- The effect of volatility is high when there is more time to expiry. This is because, with more time to expiry, higher the probability of extreme events occurring
Notice, when there were 30 days left to expiry, a change in volatility from 15% to 30% resulted in a massive 97% move in the option premium. However the same change in volatility when there were just 5 days left to expiry resulted in only a 54% move in option premium!
Let us summarize these observations into action items. The following points hold good for a simple, plain vanilla 1 leg option trade.
- When you intend to buy an option, always have a view on vega. For volatility to work in your favor, you should time the option purchase in such a way that you expect the vega to increase. This naturally means one should avoid buying options when volatility is high
- Likewise, when you intend to sell options, you should again have a view on volatility. Avoid selling options when you expect vega to increase. Which means when you are short options, for vega to work in your favor, the vega should fall
- Avoid shorting options when you are at the start of a series (more number of days to expire), and/or expect vega to increase
- When we are close to expiry, shorting options is a good idea, especially if one anticipates a drop in vega
- As a corollary to point 4, one should avoid buying options when there are just few days left to expiry, and/or when one anticipates a drop in vega
A slightly more mature option trader who trades in option spreads may wonder how would the volatility impacts the strategy cost, of let us say a 2 leg spread position such as the bull call spread or a bear put spread.
To understand the effect of volatility or the vega on the strategy cost of the spread position, have a look at the following chart.
Looking at the above graph, it is clear– increase in volatility increases the cost of strategy.
On further inspection, it is also quite evident that at the start of a new series (blue line) even with an increase in volatility, the strategy cost does not increase much. However, volatility seems to have a massive effect on the strategy cost when there are fewer days to expiry (red line).
Translating this to an action item, when you intend to initiate a spread position (bull call, bear put), always have a view on volatility, and therefore the Vega. For Vega to work in your favor:
- Ensure the vega is expected to go higher
- If you expect vega to go down, avoid taking the spread trade. One can even look at shorting the spreads
- The vega has little impact at the start of the new series (as in when there is more time to expiry)
- Initiate the spread position anytime after the midway of the expiry. This is when there is a maximum impact of volatility (assuming it is expected to increase)
One can develop visualizations to analyze the effect of vega vs time vs premium (strategy cost) on any strategy. However, the rule of thumb is the same – for a net buyer of an option, increasing vega benefits, and for a net seller of an option, decreasing vega helps.
Time has a decreasing effect on the premium. In fact for this reason options are considered a depreciating asset. Previously, we learnt about the time decay factor. However, there is another interesting and important angle to theta. It helps the trader identify the right strike to trade under a given circumstance.
To help you develop a perspective with respect to strike selection methodology (we will first deal with a long call option) we will set up few practical trading scenarios that we regularly come across.
Assume we are at the beginning of a new series, where a stock is trading at 5,000, and we are of the opinion that it will hit a target of 5,200. Given this target expectation, the objective is to select a strike in such a way that it gives the trader maximum bang for the buck.
Now, here is the situation, we are at the start of a new series (maximum number of days to expiry). Which strike of call options would you choose to trade, given the following expectation?
- We expect the target of 5,200 to be hit in 5 days
- We expect the target to be hit in 15 days
- We expect the target to be hit in 25 days
- We expect the target to be hit by expiry
Now obviously, just like the way one size does not fit all, we cannot select the same strike to trade for the above scenarios.
Have a look at the following graphs. It represents the profitability on Y axis, and strike on the X axis.
Look at the first block of chart. In the backdrop of the stock moving 5000 to 5200 within 5 days this chart is telling us what would be the profitability of each strike starting from 4700 (ITM) to 5500 (OTM). Clearly the profitability increases as you traverse from ITM to OTM. In other words, it looks like the best strike to choose in terms of profitability, would be 5500 (OTM).
However, the same strike would have lost money in the 2nd scenario, notice, 5500 actually made a small loss, even though the market moved in the right direction. Also, the graphs suggest that the best strike to choose when one anticipates the target to be hit in 15 days would be the ATM option.
You may have heard of traders say that they lost money on call option, even though the markets moved up. Now you know why this happens — they simply choose the wrong strike!
Look at the 3rd and 4th graph blocks, they are really interesting. The graph is suggesting you choose an ITM or at the best an ATM option when you expect the target to be hit towards the end of the expiry. All other strikes lose money!
Now remember, this is with respect to initiating a position at the start of the series. What if you want to initiate a fresh long call trade when we are half way through the series? Let us assume the same movement of 200 points (from 5000 to 5200), but slightly different scenarios:
- Target hits on the same day
- Target hits within 5 days
- Target hits within 10 days
- Target hits on expiry
The following graph should help you in selecting the strike:
Notice, when we expect the target to be hit on the same day, selecting an OTM option makes most sense. You may have heard of stories where traders doubled their money on the same day trading options, this is because they have selected the right strike for the right situation.
Notice in the 3rd and 4th blocks, again selecting a strike beyond ATM tends to lose money, even if the market moves in your favor.
The same logic can be applied to Long Put option. Assume we are at the start of a new series, and you expect the stock to go down from 5000 to 4800 – a 200 point down move. Here are the various scenarios:
- We expect the target to be hit in 5 days
- We expect the target to be hit in 15 days
- We expect the target to be hit in 25 days
- We expect the target to be hit by expiry
The graph below shows us which strikes seem appropriate under each of the above scenarios.
Clearly, the same inference can be drawn as we did while analyzing the call option at the start of the series.
The graph below shows the profitability trading put options when we are half way through the series and expect
- Target to hit on the same day
- Target to hit within 5 days
- Target to hit within 10 days
- Target to hit on expiry
The strike selection methodology irrespective of long call or long put are the same; hence we can generalize it with the following table.
First of all, if you have read through the entire article, kudos to you as I can imagine application of Greeks can be a fairly complicated topic, especially for a person new to this topic. If you plan to take options trading seriously it is imperative that you take the effort to learn Option Greeks and their application in detail.
In the next article, we will talk about using the options calculator to calculate the Greeks.
Until then, stay tuned – stay profitable.