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TLDR below. This is not financial advice.
Derivative tools include not only the tools for the prevention of risks but also the means to control the risks. The activities related to prevention are called risk management. It is about determining the level of risk an entity wants, identifying the level of risk it is taking, and using derivative tools to adjust the level of risk as desired.
Trying to predict what will happen to the price of an option or a position involving multiple options based on market changes can be a daunting task. Because options prices are not always in sync with the underlying asset's, it is important to understand what factors contribute to the movement's price movement and the effects they have.
Options traders usually refer to the delta, gamma, vega and theta of their option positions. These Greeks help us to understand option prices with quantitative factors. Aka using numbers to make sense of metrics that affects option pricing.
These terms may sound confusing and intimidating at first to new traders, but as we take a closer look at them, the Greeks cover simple concepts that can help you understand clearly the potential reward and risk of an options trade.
Why Do We Have To Manage Risks?
The Motivation For Risk Management
The main reasons for implementing risk valuation are concerns related to asset price volatility or other factors affecting an entity from the market.
The Benefit Of Risk Management
Increase or decrease the desired risk.
Determine the costs and profits before accepting them.
Values Of Metrics
The numbers given for each Greek are correct on a theoretical basis, which means (these) values are calculated based on mathematical models. Most of the information you need to trade options are the following: a bid/ask price, quantity, and open interest. These information are the actual data received from different options trades.
Delta And Gamma Hedge
Delta, gamma, theta, and vega indices are standardised into dollars by multiplying by the number of options contracts. This group moves when the condition changes depending on the distance between the strike price from the security's actual price, and the time remaining until maturity.
These relate to the change in underlying. E.g. if your Call option is based on $ETH, when $ETH prices change, it affects the price of your call option.
Delta measures the sensitivity of the option's value to changes in the price of an underlying asset. It is usually represented as a number between -1 and +1, and it tells us how much the value of an option will change as the price of the underlying stock increases by $1. As another convention, delta can also be expressed as a value between -100 and +100 to indicate sensitivity on an option contract. Delta shows the actual amount you will gain or lose.
For example, if you had a put option with delta = -0.3, you would lose $30 when the stock price increased by $1.
Call options have a positive delta (between 0 and 1) and put options have a negative delta (between 0 and -1). Options with a strike price equal to market price usually have a delta around (+/-)0.5.
Deep in the money options can have a delta of 0.8 or higher, while options out of the money have a delta less than 0.2.
As the share price moves, the delta changes as the option becomes in/out of the money. When an option deep in the money (delta is close to 1), it starts to trade like the underlying and move in sync with the price of the underlying. Meanwhile, out of the money options will not change much in absolute value. Delta is also a very important metric to consider when building associative positions.
Gamma measures the delta's rate of change for a one-point increase in the underlying asset. It is a valuable tool in helping you predict the delta change of an option or overall position. Gamma will be larger on at the money options and decrease when in/out of the money options. Unlike delta, gamma is always positive for both put and call options.
Theta And Vega Hedge
These relate to the components in the option itself, like time to expiry and implied volatility. When the option gets closer to expiry, its value changes. Volatility changes also affect prices. (We talked about volatility when we started chatting about options!)
Theta is a measure of the rate at which the prices decline of the options over time, the amount that an option will lose each day. For at the money options, theta increases as the option nears its expiration date. For in/out of the money options theta decreases when the option is about to expire.
Theta is one of the most important concepts for an options trader because it explains the effect of time on the hedge fees of options bought or sold. The further the expiration time, the smaller the rate of depreciation over time for an option. If you want to own an option, it makes more sense to buy contracts that have a long maturity. Conversely, if you want a strategy to benefit from devaluation, you might consider shorting short-term options, because the depreciation over time will happen quickly.
Vega is the final metric we will look at. Many people often confuse vega and volatility. Volatility measures the price movement of an underlying asset. Vega measures the sensitivity of option prices to changes in volatility. A change in volatility will affect both call and put options in the same way:
An increase in volatility will increase the price of all options on an asset
Reduced volatility causes all options to decrease in value.
However, every single option has its vega and will react to change in volatility a little differently. The effect of volatility change is greater for at the money options than for in/out of the money options. While vega affects call and put options equally, it appears to affect call options more than put options, perhaps because it is predicted that the market will always grow over time.
Use The Greeks To Perform Merged Trades
In addition to using indices on a single option, you also can use them for options position combinations. (We shared 3 combinations here.) This can help you measure the different risks of every trade, no matter how complex. Because position options have a variety of level of risk and these vary significantly over time. And with market volatility, it is important to have an easy way to capture them (as having a system).
The Greek indicators helps us to understand the risks involved. They are different for different types of options.
Because the conditions are constantly changing, "the Greeks" provides traders with the means to determine the sensitivity of a particular trade to price movements, volatility and timing. Incorporating an understanding of these indicators can be of great help to accurately price your options.
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