WEEK VII-GREEKS

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WEEK VII-GREEKS Powered By Docstoc
					THE
GREEKS
“DELTA (D), GAMMA (G),
THETA(T), VEGA(V), RHO(R)



  “It all sounds Greek to me”
• Delta is usually related to options in terms of
  referring to the rate at which an option contract will
  move in tandem with the underlying security.
• Delta was originally thought of as the hedge factor
  in determining how many options were needed to
  act exactly like the underlying investment.
• One of the biggest frustrations for an option trader
  is having an option that is in the money move
  maybe 1/2 to 3/4 for every point that the
  underlying security moves. This is a major
  frustration for traders, but most of this frustration is
  due to a lack of understanding of how Delta works
  and influences their option contracts.
Every option has a Delta value. They range from
0 to 100 in value. The put options have a value
from 0 to –100 in value.

• Example, if a option has a DELTA of 50, this
  means that for every 1 point move in the
  underlying security, the option contract would
  move 50%, or in this case of an option priced at
  $1.00, a 1/2 of a point.
•    Usually options that are near the money have
    Delta close to 50. In addition, as these options go
    deeper into the money the Deltas on those
    options tend to be closer to 70 or 80.
•    The deeper in the money, the higher the Delta of
    the option.
  DELTA
• Example: KLK is trading at 47 and the KLK
  July 45 call is priced @ $4.50 with a Delta of 70.
• Simply translated: for every one point move in
  KLK the July 45 call (with a Delta of 70) will
  move .70 or 70%.
• So if KLK went from 47 to 49, then the July 45
  call, which was trading at 4.50, will have gone
  up to 5.90 (a 1.40 move, which is 70% of 2 or
  $1.40)
• Add that 1.40 to the 4.50 and the option is
  trading at 5.90.
• Let's take a look at a couple of situations so
  you can see if you have it down.
• Please take note that this figure is strictly for
  illustration purposes so that one can see how
  generally Delta prices are figured.
• This is just a simple table to look over to get
  a visual of how Delta is figured and let you
  look at various examples
FIGURE 14-1: Look below to see how much the option will move
based on the following underlying Deltas.
• Delta is just one of the calculations that help one
  understand why an option will move in the way it
  does. However, Delta alone is not the only factor
  that determines option movement. Delta is just the
  most common due to the fact that large traders use it
  to hedge their positions at all times. Understanding
  why your options move as they do is an important
  part of the overall understanding of option pricing
  system. We will look at another important Greek term
  called Gamma next.
• The Gamma of an option tells you how
  much the Delta of an option changes as the
  underlying stock or index changes. When
  we examined Delta, we learned that every
  option has a Delta, but we need to expand
  on that knowledge to include the fact that :
• the value of that Delta changes as the stock
  value changes. As the stock goes up or
  down in value, the Delta also changes.
Scenarios
• Example: A call option, which is near the money
  and has a Delta of 50, would see an increase or
  decrease in that Delta as the price of the stock
  rises or falls
•    (e.g. If the hypothetical stock RRR was at 200
    and went up 20 points and it RRR 200 call
    increased 10 points, the Delta, which was at 50
    may change and go up to a Delta of 60.
•    The higher the stock goes, the greater the Delta
    becomes of that option as it moves deeper into
    the money).
• Gamma tells you the rate at which the option will increase or
  decrease as the stock moves up or down.
• (i.e., If the RRR 200 call, had a Gamma
  of 3
• this would mean that the Delta would
  increase 3% for every point rise in the
  stock.)
• With the stock trading at 200, Let's
  look at the example below.
•                          Delta    Gamma
• RRR Jan 220 Call @ 4        50        4
• (The above option has a Delta of 50
• The above option has a Gamma of 4.)
• This would mean that if the stock goes
  to 205
• the option that was at 4 would go to 6
  (because of the Delta being 50, then the
  Gamma of 4) would increase the Delta
  to 52 because (4% increase of 50 is 2,
  50+2 = 52 Delta).
STOCK GOES TO 210:


• If the stock goes up another 5 points to
  210, the option would go up to 9 1/8,
  and the Delta of 52 would now go up to
  54 because of the Gamma of
See the Table Below
•   RRR                           200                    205                      210

•   RRR JAN 220 Call              4                      6                        9 1/8

•   Delta >>>>>>>>>>              50                     52                       54

•   Gamma >>>>>>>>>               4                       4                       4

•   Note: This is a hypothetical example of how Delta relates to the Gamma function.

•   In the real world the Gamma would also change in relationship to the stock.
• Puts and calls have Gamma values,
  and understanding Gamma will help
  you to determine how much the Delta of
  your option will change. By using
  Gamma, you know how much the Delta
  will change and Gamma will let you
  know how quickly you must adjust your
  positions.
• Please keep in mind that this would require
  constant monitoring and a lot of time.
• Unless you are a trader who wants to
  constantly monitor positions, this should just
  be a lesson for you to become familiar with
  how Gamma and Delta work together, and
  give you a better understanding of their inner-
  workings.
• Option Hedgers are always adjusting positions
  attempting to keep these positions Delta NEUTRAL.
• Now, let's recall our definition of
  Gamma, it defines the rate or the
  speed or how much an option will
  increase or decrease Delta points
  as the underlying stock moves.
• The Delta on a call option increases with the increase
  of the stock, but as a stock decreases, so does its
  Delta.
•   Gamma just tells you how fast the change is taking
    place
•    (e.g. An option with a Gamma of 0.5 would tell us
    that for every point rise in the stock, we would have a
    1/2 point rise in the Delta of the option being traded.
    If the Gamma were 2, the Delta would increase 2
    points for every 1 point move in the stock.)
See example below:
The Real World
   GAMMA, DELTA……Houston …we have a
   problem!
• Unfortunately, just as Delta is not constant,
• Neither is Gamma.
• Gamma changes in value, just like Delta.
• The Gamma is highest when the option is at the
  money.
• The further out of the money the option is, the
  greater decreases in the Gamma, meaning slower
  and smaller changes of the Delta.
• Also, as it gets closer to expiration, Gamma will
  change.
Impact of GAMMA and DELTA

• Gamma is significant because it helps you manage
  and measure how much risk you are taking.
• We learned that Delta was important because it
  taught us that options move at varying amounts in
  relationship to the stock
• and you might also need several options to get the
  same result as the move of the underlying stock.
•    If we know Delta , we can determine how many
    options we need to equal the move of the underlying
    stock.
Importance of GAMMA and DELTA

• Gamma becomes important because Delta is
  always changing and as it changes we
  learned that one may need to readjust one's
  positions.
• Knowing Gamma helps to determine how
  quickly the Delta is going to change and put
  you in a position where you might need to
  make adjustments.
Traders use of Gamma

• Active traders use positions with
  relatively low Gammas to reduce their risk.
• The reason is because they want their
  Deltas to change less, so they don't have
  to re-adjust their positions as much.
• Large Gamma positions are
  usually considered riskier,
  because you could be caught
  long or short much quicker than
  you would like to.
• JUST A NOTE IN CLOSING on
  DELTA and GAMMA
• Gammas like Deltas have a
  negative or positive
  designation.
GAMMA Positions

• Long Positions = Positive Gammas
• Short Positions = Negative Gammas
•   Previously, we made references to how time
    affects an option as it gets closer to its expiration
    date.
•    We discussed that the value of that option will
    decrease in price because of the reduction in the
    time left until that option expires.
•   We also learned that every option has time value
    calculated in its premium,
•   all out-of-the-money options are made up entirely
    of time value.
THETA
• Theta is basically defined as the rate at which an
  option losses its value as the option gets closer
  to expiration.
•    Theta, when calculated, is usually done by a
    figure quoted in a certain number of points per
    day that the option premium will decay.
•    The unique thing that is inherent in Theta is that
    the loss of value of the option premium because
    of time decay is based on the assumption that
    there is no change in the market price of the
    option or the conditions in which the option is
    being traded.
THETA
• In other words, if you could isolate time
  value and measure strictly an individual
  variable
• and assumed the price of the option did
  not move, that would be a true measure of
  how Theta functions.
• The reason all those other factors are not
  considered is because they would
  influence the price of the options and
  affect Theta
  THETA
• Example: volatility all of a sudden picks up in a
  stock, or there are earnings rumors, buy-out
  rumors, or various national economic news).
• All of these factors would affect Theta, and
  that is why Theta, when analyzed, has to be
  looked at as if these other market factors were
  not in the equation.
• Theta works both ways in relationship to a
  buyer or a seller. If you are a buyer of an
  option, you want the option with a low Theta,
  which has a very small erosion of premium as
  time goes by.
THETA
• If you are a buyer of an option, you want
  the option with a low Theta, which has a
  very small erosion of premium as time
  goes by.
• On the other hand, if you are a seller of an
  option, you want a rapid erosion of the
  premium, giving the buyer less time to
  make a profit.
    THETA

• Theta is often most important in examining spreads.
•   As you decide which spread to put on you could examine Theta
    and make a determination whether the time value within the
    spread is going to work for you or against you.
•    By using Theta you can help better determine spreads that give
    you the best time value disposition and
• which spreads would be better for you ultimately when it comes
  down to making an educated decision as to which spread scenario
  might be best, when you have several choices to choose from.
•   This could be important, especially if you are a buyer or when
    examining the long side of your spread, whether bullish or
    bearish.
  VEGA

• Vega has had various names associated
  with it over time,
• such as Kappa or Omega.
• We will refer to it has Vega.
• Vega, in brief definition, is a value given
  in points that measures change in
  volatility. It measures a change in
  theoretical value for each 1-point
  variation in volatility.
 VEGA
• VEGA tells you how much an option will increase
  based on an increase in the volatility of option and
  the underlying stock issue.
• When you recall any number of your own personal
  option trades, as the volatility increased in you
  option, so did the premium and as volatility
  decreased or slowed down, the premium of the
  option decreased.
• The main use of Vega is to help and determine how
  much risk you have from volatility increases and
  decreases.
  VEGA
• Remember, you may have only several days to go
  on an option with little or no volatility, then all of a
  sudden:
• some market event, like a "surprise" earning report,
  would could affect the volatility either positively or
  negatively and exaggerate the price of the option,
  even though there may be only a few days left
  before its expiration.
• The net effect:
• The option being grossly overpriced due to
  volatility from investor interest in that option.
RHO
• RHO       is how an option reacts to changes in
    interest rates.
•   This Greek has a minor effect on pricing, but does have an
    effect on premium, even if negligible.
•   The Rho effect is similar to rises in interest rates.
• As interest rates go up, the option premium must increase
  to keep the options in competition with other investment
  vehicles. The premiums that the seller receives need to be
  higher to compete with the other alternatives that an
  investor has in the investment market place to choose from.
• Although Rho is part of the Greek family, its importance is
  minimal at best.
The Real World
• The Greeks are used by many traders
  to determine the various factors that
  I related to in the above text.
• On the next slide you will find an
  example of the Greeks we discussed
  and how they look to traders and
  followers of their use.
“IT ALL SOUNDS GREEK TO ME”
All the GREEKS
    GREEKS – “The Bottom Line”

• As a trader, you can see there are many, many
  trading tools that are available to attempt to give
  traders any type of edge in their attempt to
  maximize their trading profits.
• The use of Greeks are just one of the many tools
  available to traders to help achieve that goal.
  However, always remember, even the best financial
  tools are not going to substitute for excellent
  judgment, good risk/reward analysis and a sound
  investment philosophy.
•    As a trader, always try and expand your horizons
    by examining new tools and philosophies that could
    potentially serve to increase your bottom line

				
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posted:3/7/2011
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