Greeks- why they are important?

GREEKS- a Primer- Why you should care?

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There are some Co-efficents that result from the B-S module. No point discussing advance mathematics- let us get to what matters practically. I will restrict this to discussion on Delta- which perhaps will be not only easier to comprehend- but will help understand your positions

For your Info these are the brief definitions of ‘Greeks’- like Panch Pandav- if you want an Indian Context/ Of these theta and rho are usually not that important ( theta- become important if you are talking of a longer time frame)

• delta - a measure of an option’s sensitivity to changes in the price of the underlying asset
• gamma - a measure of delta’s sensitivity to changes in the price of the underlying asset
• Vega - a measure of an option’s sensitivity to changes in the volatility of the underlying asset
• theta - a measure of an option’s sensitivity to time decay
• rho - a measure of an option’s sensitivity to changes in the risk free interest rate

I have seen several posts that talking about buying or selling calls and puts- but without much understanding/ or background info. These 5 Parameters- basically will define your exposure to risk – depending on various factors. If you understand these well- then you can basically convert your position mathematically- and gain more insight as to what will happen to your trade if you vary different things- say range of movement of the underlying etc.

Let us go back to Physics 101- very basic stuff. We all hear of velocity and we all heard of acceleration- In the case of options- think of Delta as Velocity and Vega as the Acceleration ( for more mathematically inclined people this is first and second partial derivatives- but let us not worry about that!)

Why is Delta Important?
The most important reason is that you get to do what if scenarios – on what happens to your position if the underlying stock moves by say 1 rupee! The thumb rule is that ATM ( At The money) Options will have typically a delta of 0.5- , Far out of the money OTM options are close to zero, and ITM ( deep in the money) are close to 1.

In reality- the ATM will be about 0.55 to 0.6 and Even Deep ITM will have something closer to 0.9. ( For PUT’s – which mirror call’s Delta will be negative)

As the underling Asset ( Say a stock or index) moves either way- the option price moves ( all other things being constant)- if you want to know by how much, then Delta will tell you that info.

For example if you bought ATM Calls for a stock – the delta ( let us assume) is 0.5. If the Stock goes up by 20 rupees- the option should go up by 20 multiplied by 0.5 – 10 rupees ( assuming you bought 1 call option). Please notice I subtly mentioned ( All things being equal!). You do need to understand that as the underlying stock move’s the Cousin of Delta- Vega works to add “more Delta” to your position – assuming the price is going up. So basically your position will be generating more deltas than what was there originally- and making it more and more bullish. This is very important to understand- Delta is NOT static! ( Vega is like the turbo charger for Delta!)

If on the other hand you sell calls the deltas will be negative ( and it will be bearish). A equivalent argument holds for Puts- i.e. if you buy puts- you will have negative deltas- and vice versa.

So when you deal with options – please make sure you know the position delta of your trade. What is position Delta? Simply put you use a delta of 1 if you buy a stock- so if you buy 100 shares your position Delta is 1 Multiplied by 100 shares= 100 Deltas. A stock does not have Vega- that is important to remember- so delta stays at 1.

For option position- if you say buy a ATM option- delta will be about 0.5 so if you have 100 options- your position Delta will be 0.5 Multiplied by 100 i.e. 50 Deltas- Now notice the difference in deltas- for the case of buying 100 shares versus the 100 ATM options?
Which one has more Deltas? That is why it is important to know what your delta for the Option positions- to understand how bullish your position is. So in the above case- if you want to have an option position exactly similar to 100 shares ( purchase) you will have to buy ) 0.5 * 200 equals 100 Deltas- so you have to buy 200 options to simulate the same !

So why bother with options? The reason is simple- you will be paying a fraction of the price for the 200 options! So if your reasoning for a buying a stock is that – let us say it will go up 20 rupees in a week- my suggestion is you will have a better risk to reward bought equivalent Deltas using options- because your investment will be fraction ( and hence you are limiting the risk). Of course time frames etc is an important issue- with stocks if it goes down in the time frame you have- you just have a paper loss, if you are dealing with options- before expiry if your guess was not correct- then you are losing your premium! So do understand these things- and don’t blame options for burning you- it is like fire, you can do a lot of good things, but you can also destroy it if you use it callously. Remember the bonus with options is if the trade starts out bullish and gets more bullish ( i.e. stock moves more in the positive direction than you anticipated) your original delta position will keep increasing- because of our dear cousin “Vega” who is doing his job!

This in essence is the importance of delta- I will discuss Delta neutral trading in another thread.


If you know all the 5 Greeks- of your option position – basically you know a lot about your position- and can either enhance or take effective counter measures. That is why your Options ( Dream Car)- should have these 5 Dials in technicolor- in addition to IV/HV measure- Just look at how much information is hidden when you just consider the option price to make trades!

If anything- next time you do a trade- please do check your position and understand it in terms of Greeks and the IV /HV context


One very important thing to remember is the – please remember this regarding Vega- it is a 1% change in volatility not ie if Volatility is 50- the change should be 5% to get a change in price. The others are all based on absolute numbers – not percentages.
Hope this was helpful. I have tried to be as factual- but I am human so please do correct errors that may have crept in- after all I am just a volunteer.

correction in Definition of Vega the Chane should be 1% of Volatility change- but I mentioned 5% as the changed amount instead of 0.5
So remember- Volatility can pull the carpet under you if you dont pay attention!

Nice write up srikant. Just one thing here the delta illustration where u have mentioned 100 shares , i think it would be less confusing to use the term lot size since they differ here. 1 Fut. contract = 1 delta (whatever the lot size.)

I know volatility is important, but if I am writing and I anticipate a sharp swing in the underlying prices I am surely going to price it in , the result , the IV shoots up, and there is nothing a buyer can do about it (the IV), or is there? Risk reduction methods apart.

Loosing streak

I have dealt with quite a few veteran traders who called IV- just mumbo Jumbo- trust me if data is available- that makes the common guy a force to deal with- because Spotting serious IV fluctuations can lead to a lot of good opportunities- and trading just Volatility differentials is really a pretty good way!

To your point- I dont really understand why they dont have uniform market lots- but yes I am assuming an option contract covers 100 shares- uniformly. I guess you have to Indianize it a bit! And thanks for pointing that out. Let us assume there are 250 shares for a market lot for a particular scrip ( or counter as you would say)- the delta still would be 250.So market lot should not change delta.

When you say " anticipating sharp swing in prices" you are referring to the swings in Asset ( or let us underlying asset) prices. That is a diferent volatility- Called Statistical volatility. The IV is purely based on market quotes of option prices- so you get a benchmark of what is going compared to historical vol levels- did I make the point? There are times where you will not see asset prices not flucutate but - IV's really rocket- which basically is a great thing to know even if you dont trade options. High IV- and I repeat this- is a leading indicator that something is going on and there will be wide movement in asset in that particular expiration- there are times nothing pans out. But IV is not linked to the Underlying Asset movement!

You got to help me out here . As per your statement one lot of say RIL is 150 so 150 deltas .

One future contract (150) = 1 delta . How does that figure? strictly from the fno point of view.

ATM option is approx 0.5 delta right ?

One future contract mimicks 150 shares of RIL as do 2 atm options (roughly) Am I wrong somewhere?

I am aware what HV and Statistical vol is , But what I am pricing in when anticipating sharp price swings of the underlying , whether they happen or not would have to be IV. As u have said there are times nothing pans out.

IV is definitely linked to how much the market expects the asset to move.

dear srikanth,
an informative write up but I will be glad if you can tell me

1) How to calculate “DELTA” for an option ?
2) How to calculate “VEGA” for an option ?
3) How to calculate “THETA” for an option ?


with regards,

learningcurve

Good write up for the newbies like me...Thanks. However the options market is yet to mature in India (my feeling only) if we see the illiquidity in almost all but a very few selected counters. The spread is usually toooooo big in illiquid counters having no parity at all with the Greeks.
I have paper tarded covered positions and have more often lost than made money in Options.
Trust your write ups shall be useful.
Regards

Excellent Srikanth,
good work. keep it up.

Rgds
Parv

srikant,
Thks for helping us Learn these things which are still truly 'Greek' to me ,however your post no 4 ,will be a Gr8 thing to Learn ,the "Leading Indicator" part ,will have to study.
Thks for drawing our attention to the matter.
Asish

Let us assume 1 futures contract covers 150 RIl Shares. - so that would be 150 Deltas ( 1 Multiplied by 150)

Now if 1 option covers 150 RIL shares and you are looking at the ATM options- their delta is 0.5 , the position delta is 0.5 multiplied by 150( here we assumed that 1 Option contract covers 150 shares) - which is 75 deltas. ( this is the position delta!)

Futures dont have a strike price- so essentially you have to multiply the delta of 1 by number of shares a futures contract controls.

Let me also tell you I dont trade futures as stock futures are not that popular here- although a combination of stock, futures and options offer a great way to hedge positions as needed.

IV is what you get out of option prices as quoted- and you are correct they tell you about market expectation. BUT the key point is HV and IV are very different. MY objection or let us say disagreement was that it is not about movement of asset pricesitself- but the "factored in" volatilility as reflected by option prices- there is a nuance here.