Anatomy of Options

It is important for option traders to understand the complexity of options. Understanding the structure of options allows traders to use reasonable judgments and provides them with more options for executing trades.

Greek

The value of options has several elements that are closely related to the “Greeks”:

  1. The price of the underlying security
  2. Expire date
  3. Implied volatility
  4. Actual execution price
  5. Dividends
  6. interest rate

The “Greeks” provide important information about risk management and help rebalance the portfolio to achieve the required risk exposure (for example, delta hedging). Every Greek measures how the investment portfolio reacts to small changes in specific underlying factors, so that personal risks can be checked.

delta Measures the rate of change in the value of options related to changes in the price of the underlying asset.

Gamma Measures the delta change rate associated with the price change of the underlying asset.

The percentile change of Lambda or Elasticity and Option Value is compared with the percentile change of the underlying asset price. This provides a way to calculate leverage, which can also be referred to as leverage.

Theta calculates the sensitivity of the option value to the passage of time. This factor is called “time decay”.

Vega measures sensitivity to fluctuations. Vega is an indicator that measures the volatility of the value of an option relative to the underlying asset.

Rho assesses the responsiveness of option value to interest rates: it is a measure of option value relative to risk-free interest rates.

Therefore, using the Black Scholes model (considered the standard model for evaluating options), the Greeks’ determination is quite simple and very useful for day traders and derivatives traders. For measuring time, price and volatility, delta, theta and vega are effective tools.

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The value of an option is directly affected by the “expiry time” and “volatility”, among which:

  • A longer time before expiration tends to increase the value of call options and put options. The opposite is also true, because a short period of time before expiration is likely to cause the value of call options and put options to decrease.
  • Where volatility increases, the value of call options and put options will increase, and a decrease in volatility will cause the value of call options and put options to decrease.

Compared with put options, the price of the underlying security has a different effect on the value of the call option.

  • Generally, as the price of the security rises, the corresponding direct call option will rise as the price rises, and the value of the put option will fall.
  • When the price of a security falls, the situation is just the opposite. Direct call options generally fall in value, while put options rise in value.

Option premium

This happens when a trader buys an option contract and makes an advance payment to the seller of the option contract. This option premium will vary, depending on its calculation time and the option market purchased. According to the following criteria, the premium may even be different in the same market:

  • Are options in the money, in the money or out of the money? In-the-money options will be sold at a higher premium because the contract is already profitable and the buyer of the contract can immediately obtain this profit. Conversely, you can buy at-the-money or out-of-the-money options at a lower premium.
  • What is the time value of the contract? Once an option contract expires, it becomes worthless, so the longer the time span to the expiration date, the higher the premium, which is natural. This is because the contract contains additional time value, because there is more time to make the option profitable.
  • What is the level of market volatility? If the options market is more volatile, the premium will be higher because the possibility of higher profits from options increases. The reverse also applies-lower volatility means lower premiums. The volatility of the options market is determined by applying various price ranges (long-term, near-term, and expected price ranges are required data) to a series of volatility pricing models.

Call options and put options have no matching value when they reach their mutual ITM, ATM, and OTM strike prices because they become uneven due to the direct and opposite effects of swinging between irregular distribution curves (example below).

Strikes are the number of strikes, and the increment between strikes is determined by the exchange that trades the product.

Option pricing model

When using historical volatility and implied volatility for trading purposes, it is important to note the differences they imply:

Historical volatility calculates the rate at which the underlying asset undergoes changes in a specific period of time-where the annual standard deviation of price changes is given as a percentage. It measures the degree of volatility of the underlying asset during the previous trading day (modifiable period) of the specified number before each calculation date in the information series within the selected time range.

Implied volatility is a combined future estimate of the trading volume of the underlying asset, and provides an indicator to measure how the daily standard deviation of the asset changes between the calculation time and the option expiration date. When analyzing the value of options, implied volatility is one of the key factors that day traders should consider. When calculating the implied volatility, the option pricing model is used, and the cost of option premium is considered.

Day traders can use three commonly used theoretical pricing models to help calculate implied volatility. These models are Black-Scholes, Bjerksund-Stensland and Binomial models. The calculations are done using algorithms-usually call and put options at par or nearest price are used.

  1. The Black–Scholes model is most commonly used for European options (these options can only be exercised on the expiry date).
  2. The Bjerksund-Stensland model is effectively applied to American options, which can be exercised at any time between the purchase contract and the expiry date.
  3. The binomial model is suitable for American, European and Bermudan options. Bermuda is a bit between European and American. Bermuda options can only be exercised on a specific date or expiry date during the contract period.

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READ ALSO:   Options Industry Council (OIC)
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