Option prices can change due to directional price shifts in the underlying asset, changes in the implied volatility, time decay, and even changes in interest rates. Understanding and quantifying an option's sensitivity to these various factors is not only helpful -- it can be the difference between boom and bust.
The Greeks are risk measures that can help you choose which options to buy and which to sell. With options trading you must have an idea of the direction of the underlying as well as a view of the direction of implied volatility, and then factor in the timing.
The Greeks help you tailor your strategy to your outlook. Spreads, for instance, can help option buyers reduce theta and vega risk. Understanding the Greeks gives you even more of an edge in this zero sum game of options trading
Delta
Delta is a measure that can be used in evaluating buying and selling opportunities. Delta is the option's sensitivity to changes in the underlying stock price. It measures the expected price change of the option given a $1 change in the underlying.
Calls have positive deltas and puts have negative deltas. For example, with the stock price of XYZ at $21.48, let's say the XYZ Feb 22.5 call has a delta of .35. If XYZ goes up to $22.48, the option should increase by $0.35.
The delta also gives a measure of the probability that an option will expire in the money. In the above example, the 22.5 call has a 35 percent probability of expiring in the money (based on the assumptions of the Black-Scholes model).
But note: This does not give us the probability that the stock price will be above the strike price any time during the options life, only at expiration.
Delta can be used to evaluate alternatives when buying options. At-the-money options have deltas of roughly .50. This is sensible, as statistically they have a 50 percent chance of going up or down.
Deep in-the-money options have very high deltas, and can be as high as 1.00, which means that they will essentially trade dollar for dollar with the stock. Some traders use these as stock substitutes, though there are clearly different risks involved.
Deep out-of-the-money options have very low deltas and therefore change very little with a $1 move in the underlying. Factoring in commissions and the bid/ask spread, low delta options may not make a profit even despite large moves in the underlying. Thus we see that comparing the delta to the options price across different strikes is one way of measuring the potential returns on a trade.
Option sellers also can use the delta as a way to estimate the probability that they will be assigned. Covered call writers usually do not want to be assigned and so can use the delta to compare the probability with the potential return from selling the call.
Advanced traders often use "delta neutral" strategies, creating positions where the total delta is close to zero. The idea is these positions should profit regardless of moves up or down in the underlying. This approach has its own risks, however, and generally requires frequent adjustments to remain delta-neutral.
To review, delta is the option's sensitivity to the underlying price. The delta tells us how much an options price will change with a $1 move in the underlying. At-the-money options have a delta of roughly .50 and therefore will change roughly $.50 for every $1 change - up or down - in the underlying stock.
Theta
Theta is the option's sensitivity to time. It is a direct measure of time decay, giving us the dollar decay per day. This amount increases rapidly, at least in terms of a percentage of the value of the option, as the option approaches expiration. The greatest loss to time decay is in the last month of the options life. The more theta you have, the more risk you have if the underlying price does not move in the direction that you want.
Option sellers use theta to their advantage, collecting time decay every day. The same is true of credit spreads, which are really selling strategies. Calendar spreads involve buying a longer-dated option and selling a nearer-dated option, taking advantage of the fact that options expire faster as they approach expiration.
We can look at JDS Uniphase (JDSU) as an example. Going into earnings, the implied volatility was highest for the May options, up at 64 percent. Theta for the at-the-money calls was -.04 and for out-of-the-money calls was -.03. June options had an implied volatility of 50 percent and the theta the ATM calls was -.02 and for OTM calls was -.01.
Thus a calendar spread consisting of buying a June call and selling the May call would give you a positive theta of +.02. Whereas simply buying a May ATM call would give you a theta of -.04.
A JDSU May ATM call spread against an OTM call (a vertical spread: buying ATM, selling OTM) would gives you a theta of -.01, still negative, but much reduced.
Vega
Vega is the option's sensitivity to changes in implied volatility. A rise in implied volatility is a rise in option premiums, and so will increase the value of long calls and long puts. Vega increases with each expiration further out in time.
Gamma
The gamma metric is the sensitivity of the delta to changes in price of the underlying asset. Gamma measures the change in the delta for a $1 change in the underlying. This is really the rate of change of the options price, and is most closely watched by those who sell options, as the gamma gives an indication of potential risk exposure if the stock price moves against the position.
Rho
Rho is the option's sensitivity to changes in interest rates. Most traders have little interest in this measurement. An increase in interest rates decreases an options value because it costs more to carry the position.
Using the Greeks to Buy a Call
Buying stock is a relatively easy process. If you think it is going up, you buy it. But when using options, there are several additional layers of complexity and decisions to be made - what strike?, which expiration? We can use the Greeks to help us make these decisions.
First we can look at the delta. The at-the-money call will have a delta of .50. This tells us two things. One, the option will increase (or decrease) by $.50 for every $1 move in the underlying stock. If a stock is trading for $25 and the 25 strike call (delta of .50) is trading for $2, then if the stock goes to $26, then the option should be worth roughly $2.50.
Out-of-the-money calls will have a delta of less than .50 and in-the-money calls have a delta greater than .50 and less than 1.
Two, the delta tells the probability of expiring in the money. A deep-in-the-money call will have an option close to 1, meaning that the probability that it will expire in the money is almost 100 percent and that it will basically trade dollar for dollar with the stock.
Theta is greatest for the near-term options and increases exponentially as the call approaches expiration. This works against us in buying short-dated options. It also gives us the least amount of time for our position to work out. Buying longer-term options - at least two to three months longer than we plan on holding the option - usually makes sense from this perspective.
We must balance this out with the Vega of the call. The further out in time you go out, the higher the Vega. The practical import of this is that if you are buying options with higher implied volatility (often the case before earnings, or when professional money managers are purchasing in big blocks), you have more exposure using those longer-dated options.
So, we are still left with the question of which option to buy. The answer, as with most things, is which one will give you the most bang for the buck. First, for any given underlying, look for the option with the lowest implied volatility. This will have the lowest relative theta and Vega exposure, and will be the best return on investment.
The next step is to do a comparison of the delta, theta and Vega relative to the actual options price. Deep-in-the-money calls have the highest delta and lowest theta and Vega, but they are probably not the best compared to the price of the option. They also have the most total capital tied up and thus at risk.
Far out-of-the-money options, on the other hand, can also have low Vega and theta, and always have a low delta, but again, those values may not be the best relative to the price of the option. And their probability of profit is very low.
"Near the money" options, two to three months out (depending on how long you want to hold the option) usually provide the best relative delta, theta, and vega compared to the price of the option - the most bang for the buck.
The Greeks are risk measures that can help you choose which options to buy and which to sell. With options trading you must have an idea of the direction of the underlying as well as a view of the direction of implied volatility, and then factor in the timing.
The Greeks help you tailor your strategy to your outlook. Spreads, for instance, can help option buyers reduce theta and vega risk. Understanding the Greeks gives you even more of an edge in this zero sum game of options trading
Delta
Delta is a measure that can be used in evaluating buying and selling opportunities. Delta is the option's sensitivity to changes in the underlying stock price. It measures the expected price change of the option given a $1 change in the underlying.
Calls have positive deltas and puts have negative deltas. For example, with the stock price of XYZ at $21.48, let's say the XYZ Feb 22.5 call has a delta of .35. If XYZ goes up to $22.48, the option should increase by $0.35.
The delta also gives a measure of the probability that an option will expire in the money. In the above example, the 22.5 call has a 35 percent probability of expiring in the money (based on the assumptions of the Black-Scholes model).
But note: This does not give us the probability that the stock price will be above the strike price any time during the options life, only at expiration.
Delta can be used to evaluate alternatives when buying options. At-the-money options have deltas of roughly .50. This is sensible, as statistically they have a 50 percent chance of going up or down.
Deep in-the-money options have very high deltas, and can be as high as 1.00, which means that they will essentially trade dollar for dollar with the stock. Some traders use these as stock substitutes, though there are clearly different risks involved.
Deep out-of-the-money options have very low deltas and therefore change very little with a $1 move in the underlying. Factoring in commissions and the bid/ask spread, low delta options may not make a profit even despite large moves in the underlying. Thus we see that comparing the delta to the options price across different strikes is one way of measuring the potential returns on a trade.
Option sellers also can use the delta as a way to estimate the probability that they will be assigned. Covered call writers usually do not want to be assigned and so can use the delta to compare the probability with the potential return from selling the call.
Advanced traders often use "delta neutral" strategies, creating positions where the total delta is close to zero. The idea is these positions should profit regardless of moves up or down in the underlying. This approach has its own risks, however, and generally requires frequent adjustments to remain delta-neutral.
To review, delta is the option's sensitivity to the underlying price. The delta tells us how much an options price will change with a $1 move in the underlying. At-the-money options have a delta of roughly .50 and therefore will change roughly $.50 for every $1 change - up or down - in the underlying stock.
Theta
Theta is the option's sensitivity to time. It is a direct measure of time decay, giving us the dollar decay per day. This amount increases rapidly, at least in terms of a percentage of the value of the option, as the option approaches expiration. The greatest loss to time decay is in the last month of the options life. The more theta you have, the more risk you have if the underlying price does not move in the direction that you want.
Option sellers use theta to their advantage, collecting time decay every day. The same is true of credit spreads, which are really selling strategies. Calendar spreads involve buying a longer-dated option and selling a nearer-dated option, taking advantage of the fact that options expire faster as they approach expiration.
We can look at JDS Uniphase (JDSU) as an example. Going into earnings, the implied volatility was highest for the May options, up at 64 percent. Theta for the at-the-money calls was -.04 and for out-of-the-money calls was -.03. June options had an implied volatility of 50 percent and the theta the ATM calls was -.02 and for OTM calls was -.01.
Thus a calendar spread consisting of buying a June call and selling the May call would give you a positive theta of +.02. Whereas simply buying a May ATM call would give you a theta of -.04.
A JDSU May ATM call spread against an OTM call (a vertical spread: buying ATM, selling OTM) would gives you a theta of -.01, still negative, but much reduced.
Vega
Vega is the option's sensitivity to changes in implied volatility. A rise in implied volatility is a rise in option premiums, and so will increase the value of long calls and long puts. Vega increases with each expiration further out in time.
Gamma
The gamma metric is the sensitivity of the delta to changes in price of the underlying asset. Gamma measures the change in the delta for a $1 change in the underlying. This is really the rate of change of the options price, and is most closely watched by those who sell options, as the gamma gives an indication of potential risk exposure if the stock price moves against the position.
Rho
Rho is the option's sensitivity to changes in interest rates. Most traders have little interest in this measurement. An increase in interest rates decreases an options value because it costs more to carry the position.
Using the Greeks to Buy a Call
Buying stock is a relatively easy process. If you think it is going up, you buy it. But when using options, there are several additional layers of complexity and decisions to be made - what strike?, which expiration? We can use the Greeks to help us make these decisions.
First we can look at the delta. The at-the-money call will have a delta of .50. This tells us two things. One, the option will increase (or decrease) by $.50 for every $1 move in the underlying stock. If a stock is trading for $25 and the 25 strike call (delta of .50) is trading for $2, then if the stock goes to $26, then the option should be worth roughly $2.50.
Out-of-the-money calls will have a delta of less than .50 and in-the-money calls have a delta greater than .50 and less than 1.
Two, the delta tells the probability of expiring in the money. A deep-in-the-money call will have an option close to 1, meaning that the probability that it will expire in the money is almost 100 percent and that it will basically trade dollar for dollar with the stock.
Theta is greatest for the near-term options and increases exponentially as the call approaches expiration. This works against us in buying short-dated options. It also gives us the least amount of time for our position to work out. Buying longer-term options - at least two to three months longer than we plan on holding the option - usually makes sense from this perspective.
We must balance this out with the Vega of the call. The further out in time you go out, the higher the Vega. The practical import of this is that if you are buying options with higher implied volatility (often the case before earnings, or when professional money managers are purchasing in big blocks), you have more exposure using those longer-dated options.
So, we are still left with the question of which option to buy. The answer, as with most things, is which one will give you the most bang for the buck. First, for any given underlying, look for the option with the lowest implied volatility. This will have the lowest relative theta and Vega exposure, and will be the best return on investment.
The next step is to do a comparison of the delta, theta and Vega relative to the actual options price. Deep-in-the-money calls have the highest delta and lowest theta and Vega, but they are probably not the best compared to the price of the option. They also have the most total capital tied up and thus at risk.
Far out-of-the-money options, on the other hand, can also have low Vega and theta, and always have a low delta, but again, those values may not be the best relative to the price of the option. And their probability of profit is very low.
"Near the money" options, two to three months out (depending on how long you want to hold the option) usually provide the best relative delta, theta, and vega compared to the price of the option - the most bang for the buck.
------------****************///////////////*****************----------
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THE TALE OF OPEN INTEREST
As the name
suggests, Open Interest (OI) is the INTEREST that is OPEN. What is
INTEREST? INTEREST is the POSITIONS of TRADERS. And What is OPEN? OPEN
means OUTSTANDING. So, OPEN INTEREST means POSITIONS of TRADERS which
are OUTSTANDING and not yet squared off. There are only two type of
positions that a trader can take in the market. LONG & SHORT. Now,
since for every LONG there is a SHORT and for every SHORT there is a
LONG, so we don't count OI as LONG + SHORT but either TOTAL LONGS or
TOTAL SHORTS. They both would always be equal. So, as I said OI is a
number that tells you how many futures (or Options) contracts are
currently outstanding (open) in the market. So, Let us say the seller
sells 1 contract to the buyer. The buyer is said to be LONG on the
contract and the seller is said to be SHORT on the same contract. The
open interest in this case is said to be 1 not 2.
HOW CAN YOU JUDGE BULLISHNESS OR BEARISHNESS WITH OI DATA
1.) If PRICE is rising and OI is rising, it means market is STRONGLY BULLISH.
DESCRIPTION:
If PRICE and OI both are rising, it means that ever new contract that
is being added is dominated by bulls, that's why PRICE is rising with
every new contract addition. Never think that since PRICE is rising,
more LONGS are being created than SHORTS. LONGS will always be equal to
SHORTS just that LONGS are dominating SHORTS in the transaction, that is
why PRICE is rising. See, it's like a normal share transaction. Number
of shares bought is ALWAYS EQUAL to number of shares sold. Then why
PRICE rises or falls? It does so because of buying pressure or selling
pressure. So, if buyers of a share are dominating the sellers, PRICE
will rise and if sellers are dominating the buyers, PRICE will fall. But
BUYERS will always be equal to SELLERS. So,, OI is rising, means new
contracts are being added. But since PRICE is rising with it, it means
that LONGS are DOMINATING the transactions. Thus, market/share is
STRONGLY BULLISH.
2.) If PRICE is rising but OI is falling, it means market is WEAKLY BULLISH.
DESCRIPTION:
If PRICE is rising but OI is falling, it means that the rise in price
is due to SHORT COVERING and not bullishness. See why is OI falling?
It's falling because positions are being squared off and number of open
contracts in the market are reducing. But since PRICE is rising with it,
it means that SHORTS are SQUARING OFF and dominating LONGS in the
transaction. See, how would SHORTS square off? They will square off by
BUYING. That is why PRICE is rising. So, PRICE is not rising because
LONGS are dominating. It is rising because SHORTS are dominating the
squaring off process. Thus, it can not be called BULLISH. It is WEAKLY
BULLISH. It can be a TRAP for new LONGS.
3.) If PRICE is falling, OI is rising, market is STRONGLY BEARISH.
DESCRIPTION:
If price is falling and OI is rising, it means that SHORTS are
dominating the LONGS. And since OI is rising, it means that new
contracts are being added. But, since price is falling, it means the new
contracts which are being added are dominated by SHORTS not LONGS.
Hence, it is STRONGLY BEARISH.
4.) If PRICE is falling and OI is falling, market is WEAKLY BEARISH.
DESCRIPTION:
If PRICE is falling and OI is falling, it means that the fall in price
is due to LONG COVERING or also called LONG UNWINDING. See why is OI
falling? It's falling because positions are being squared off and number
of open contracts in the market are reducing. But since PRICE is
falling with it, it means that LONGS are SQUARING OFF & dominating
SHORTS in the transaction. See, how would LONGS square off? They will
square off by SELLING. That is why PRICE is falling. So, PRICE is not
falling because SHORTS are dominating and creating new positions. It is
falling because LONGS are dominating the squaring off process. Thus, it
can not be called BEARISH. It is WEAKLY BEARISH. It can be a TRAP for
new SHORTS.
DISTINCTION BETWEEN VOLUME & OI
Just remember, volume is number of contracts traded and OI is number of outstanding contracts which are not squared off.
Let's summarize these with an easy-to-read chart:
Price Volume Open Interest Market
1.Rising Up Up Strong
2.Rising Down Down Weak
3.Declining Up Up Weak
4.Declining Down Down Strong
In other words,
Relationship between Price and Open interest
Cumulative Open Interest - (COI) - OI of near month Future + OI of mid month Future + OI of far month Future
In other words,
Relationship between Price and Open interest
| Price | OI | Position |
| UP | UP | Long |
| Down | UP | Short |
| UP | Down | Short Covering |
| Down | Down | Long Unwinding |
Cumulative Open Interest - (COI) - OI of near month Future + OI of mid month Future + OI of far month Future
RULES OF OPEN INTEREST::
1. If
prices are rising and open interest is increasing at a rate faster than its
five-year seasonal average, this is a bullish sign. More participants are
entering the market, involving additional buying, and any purchases are
generally aggressive in nature.
2. If the
open-interest numbers flatten following a rising trend in both price and open
interest, take this as a warning sign of an impending top.
3. High
open interest at market tops is a bearish signal if the price drop is sudden,
since this will force many 'weak' longs to liquidate. Occasionally, such
conditions set off a self-feeding, downward spiral.
4. An
unusually high or record open interest in a bull market is a danger signal.
When a rising trend of open interest begins to reverse, expect a bear trend to
get underway.
5. A
breakout from a trading range will be much stronger if open interest rises
during the consolidation. This is because many traders will be caught on the
wrong side of the market when the breakout finally takes place. When the price
moves out of the trading range, these traders are forced to abandon their
positions. It is possible to take this rule one step further and say the
greater the rise in open interest during the consolidation, the greater the
potential for the subsequent move.
6. Rising
prices and a decline in open interest at a rate greater than the seasonal norm
is bearish. This market condition develops because short covering and not
fundamental demand is fueling the rising price trend. In these circumstances
money is flowing out of the market. Consequently, when the short covering has
run its course, prices will decline.
7. If
prices are declining and the open interest rises more than the seasonal
average, this indicates that new short positions are being opened. As long as
this process continues it is a bearish factor, but once the shorts begin to
cover it turns bullish.
8. A
decline in both price and open interest indicates liquidation by discouraged
traders with long positions. As long as this trend continues, it is a bearish
sign. Once open interest stabilizes at a low level, the liquidation is over and
prices are then in a position to rally again.
REFERENCE
1. On Momentum - Martin Pring
--------------------******************-------------------------------
1 Open Interest
This is the total number of outstanding positions in the
futures and options market, or the unsettled contracts, at the end of the day.
It is the most widely tracked indicator and is reported in real time. When seen
in conjunction with the stock price, it can be a good indicator for buying or
selling.
Put to Call Ratio
It is a useful indicator to gauge the market sentiment and
is calculated by dividing the volume of all puts traded on a given day by the
volume of calls traded on that day.
3Implied Volatility
It is the expected volatility of a stock (or index) and is
derived using the option price or option premium. It is expressed as a
percentage of the stock price and is calculated on an annualized basis.
Typically, the higher the implied volatility, the higher the option premium,
and vice versa. So, if you are an option writer, the options with rising
implied volatility will be beneficial as they will command a higher premium.
If you are an option buyer, you should look for options with falling implied volatility.
4 Cost of Carry
It's the cost of holding a position. A rising cost of carry
indicates buying pressure, whereas a falling cost of carry signals bearishness.
For a stock, it's calculated by using the risk-free rate. So, if one pays Rs
50,000 to buy a futures contract for three months, the carrying cost will be
the interest one would have earned if this sum were to be deposited at
risk-free rate.
Taking this rate, or 10-year government bond yield rate, at
8% per annum, the carrying cost for holding futures for three months is Rs. 875
(50,000 X 8%) x (3/12). The futures price is calculated by adding the cost of
carry to the spot price
