To The Moon

Welcome back. Let's continue with where we left previously. Warning: This post will be heavy. If u need more time to digest and find out more, dun worry, it’s perfectly normal. Hope that this post, can add to ur financial knowledge, regardless of ur preference towards options. What are the option Greeks? Let’s start with the background. Options doesn’t comprise of just price alone. There is also a time element as we have to decide how much time the contract has. But u may also wonder, if options is based on just price and time, why does it seem so complicated? The complication lies with volatility. Let’s use a more common term, risk. Let’s use a real life example that most of us should be familiar with: insurance contract. Specifically accident insurance When we buy insurance contract, does the Insurance Agent ask u these questions? 1. How much $ u want to be insured up to, in the event of the accident/event occurring? (Strike price) 2. How long do u want the insurance to last? (Time) 3. Do u smoke? Have high blood pressure? Any hereditary issues? (Risk) 4. After calculating the above, we would like to offer u a insurance contract at the rate of $100/month. Are u agreeable with the price? (Options premiums) Hmm… missing something? How to measure the price? Ahem… if u are not paying, u are the product… In this case, U are the underlaying product. How healthy u are, how likely u are to catch covid, how much bungee jumping u want to do, will affect ur value/worth in the eyes of an insurance company. (Price) Let’s look at a extremely simplified version of how I feel options is priced: Option premiums = % of price of stock + contract time+ risk If we look at it from the insurance angle, they do price their contract to us in a similar way. How much we are paying them, let’s say monthly, is based on the returns we expect of the event happen, agreed time frame for the insurance to be enforced/liability for insurance company and also perceived risk that we will give to the insurance company. The concept is as below: Option premiums = % of price of stock + contract time+ risk What if we name it differently: Options premiums = Delta (%price of stock) + Gamma (change of delta) + theta (time) + Vega (risk) Eh, in reality it’s worse than that. It’s like this: 🤔 which equation will u prefer? Suddenly does this feels easier? Options premiums = Delta (%price of stock) + Gamma (change of delta) + theta (time) + Vega (risk) Do take note that this simplified version is about the concept, and not the actual calculation. U are welcome to challenge the actual calculation above. 🤣🤣🤣. Let’s break down the components: Options premiums is the amount of $$$ u will get from the selling of the options contract, or the amount that u have to pay if u are buying the options contract. The remaining components are known as option Greeks. There are even more of them, but let’s just focus on the important ones as below. 1. Delta 2. Gamma 3. Theta 4. Vega Let me use a crazy example. I wonder if u guys know them: Let’s use them as imagery to make ur life easier…. ———————————————————— DELTA: Delta is the most important of the 4 greek options. Let’s associate Leonardo with delta, since they can be regarded as leaders of the pack. Delta can be used in the following ways: A) Shows the correlation between stock price and option price. The higher the delta, the more the option will behave like a stock. We can treat stocks as 1 and delta as a portion of that. Eg. delta of 0.9 will be 90% similar to stock movement ($1 move of stock vs $0.90 move of option) and delta of 0.6 will be 60% similar to the stock movement ($1 move of stock vs $0.60 move of option) As options are derivatives of stocks, similar as wool from sheep, no matter how much wool the sheep have. It cannot replace the sheep. Why is delta important in this case? Different strategies use delta differently. Let’s use buying strategies first. For option buyers, u will want high delta, so that the option will gain value faster when the stock price goes up. Last thing u will want, is that the stocks are flying to the moon and u have a delta 0.2 option. Stocks up $1, options up $0.20 We can also use delta as option seller to create a delta neutral position. Which means we have no direction in mind. We can sell a 0.20 delta call and sell a -0.20 delta put. (Calls have positive delta, whereas puts have negative delta). The 2 deltas will cancel off, leaving u in a scenario, where u will profit as long as the stocks dun fly up or down. We will explore in detail at strategy portion. Can see the association with Leonardo? He sets the direction for the team. B) Probability of expiration ITM Delta can also be used to find probability of success of ur positions before the trade commence. How so? Recall the delta values of say 0.2? This value means that there is a 20% chance of the option being in the money. In other words, the chance insurance company being claimed by claimant as accident happened. This value is usually mainly by option sellers, as it serves as a guide for risk reward ratio. I will elaborate when sharing on selling options strategy. GAMMA: We move on to Gamma next. Gamma is very close to delta in relationship. U can say that it’s brother like behaviour. Gamma measures the change of delta. Let’s see, in layman terms, using the sheep and wool as the example, we can associate Gamma as the rate of wool growing or slowing. Ok, hang on, we are missing a turtle. Y Raphael? It’s cos Gamma can also be viewed based on acceleration, how fast delta changes or viewed in another light, how aggressively it changes. Raphael is aggressive and the fighter of the group. How does gamma affect options? Gamma raises option prices under 2 conditions: 1. Nearer to the money, in other words when prices moves nearer to the strike price, the faster gamma will increase delta. This will result in a quicker increase in option prices which is Good for option buyers and conversely bad for option sellers. 2. The lesser time there is, the more aggressive Gamma is, and the faster delta will move. Again, this is good for option buyers and bad for option sellers as option prices may suddenly whipsaw as every $ move, suddenly results in bigger option price moves. Option buyers can use the properties of gamma to increase returns, whereas option sellers treat Gamma as a risk. To reduce Gamma risk, option sellers tend to sell contracts with more time on hand, to prevent Raphael whacking havoc on them. THETA: Theta is the quieter one who works in the background. There can only be 1 turtle. Donatello does machine, who works behind the scene, same as theta. Theta measures the decay of time. Recall that options have fixed contract duration? Every day that passes, the insurance company will have lesser and lesser liability. The lesser the time, the lesser the risk. We do have to quantity the reduction of risk through $$$. Hence theta comes to play. Theta can be regarded as the amount of $ u will receive per day, if there are no other changes. Theta is positive for option sellers, as with each passing day, theta will pass money to option sellers. Theta is conversely bad for option buyers, as they have lesser time with each passing day to make the move that they want. Since we are on time decay, do take note of the below: U can see that time decay will accelerate towards the end, which makes option sellers earn more money then in theory. There is always a debate between selling weekly (expire in 1 week) or monthly options (expire in 1 month). As the shorter the time frame, the faster the gain for option sellers. In theory it’s correct, when we look at theta alone. Just be careful of Raphael. Donatello dun stand a chance against him if Raphael acts up during the last week. Raphael May cause prices to shoot up suddenly. VEGA: Finally, its the last one. 😅 Vega measures the rate of change of implied volatility (IV) in the options. In other words, u can look at it as the risk levels. Recall that insurances measure risk and package it? Same goes for options contract. The higher the risk of the underlaying, the higher the volatility. The higher the risk, the more the option seller will ask for more money before he is willing to open the contract. Ok, missing turtle. The higher Michelangelo gets, the wilder the party. When Michelangelo goes wild, prices swing up and down more. An example will be the Meme stocks, their IV is crazy high. GME is > 110% AMC > 140%. Blue chips like P&G has IV around 25%. Ya, so when u have a loony turtle running around, IV will spike and Vega goes up, expect big price swings. In real life events, when Russia strikes, expect companies which are affected to suddenly have spikes in their IV. Ok, back to how to use Vega. Vega is highest at the strike price and will drop the further u are away from it. In this aspect, u will see Raphael and Michelangelo party together at the strike price, creating wild parties there. The other consideration will be Donatello dun play well with Michelangelo. One creates too much noise, the other prefers peace and quiet. What does this mean? Theta decay (time decay) is the fastest the lesser the time, whereas The more time there is, the higher the Vega value. Vega need more time to be throwing parties. Parties that are going to end soon, ain’t fun for parties. Phew, that’s heavy. That is the last Greek that I want to share, no more turtles anyway. Hope everyone is able to benefit from this post. I doubt that it’s financially correct, but well at least can't say that I haven't tried. [Cool] Will end off here for this post. Thanks everyone For sticking through the longest and most boring portion of options.