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International Securities Exchange. Alex Jacobson Vice President, Education www.iseoptions.com. Understanding The Option Greeks And Their Importance In Setting Expectations. ISE EDUCATION WEBINAR October 2006.
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International Securities Exchange Alex JacobsonVice President, Educationwww.iseoptions.com
Understanding The Option Greeks And Their Importance In Setting Expectations ISE EDUCATION WEBINAR October 2006
For the sake of simplicity, the examples that follow do not take into consideration commissions and other transaction fees, tax considerations, or margin requirements, which are factors that may significantly affect the economic consequences of a given strategy. An investor should review transaction costs, margin requirements and tax considerations with a broker and tax advisor before entering into any options strategy. Options involve risk and are not suitable for everyone. Prior to buying or selling an option, a person must receive a copy of CHARACTERISTICS AND RISKS OF STANDARDIZED OPTIONS. Copies have been provided for you today and may be obtained from your broker, one of the exchanges or The Options Clearing Corporation. A prospectus, which discusses the role of The Options Clearing Corporation, is also available, without charge, upon request at 1-888-OPTIONS or www.888options.com. Any strategies discussed, including examples using actual securities price data, are strictly for illustrative and educational purposes and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities.
www.iseoptions.com • Free volatility data on all ISE listed options • Updates on ISE broad market index products • Updates on ISE sector options • education@iseoptions.com
Fact • All options strategies work • They each describe a specific set of expected outcomes -- Price action --Volatility -- Time • No strategy works all the time
Option Pricing To calculate an option’s value, you need: • The Price of the underlying • The Strike Price of the option • The Time until the option expires • The Cost of Money (Interest Rates less dividends, if any) • The Volatility = Theoretical Value of the Option
Option Nationalities • European Options Index Options Trade all day Exercise only at expiration Friday • American Options Stock options ETF options Trade all day Can be early exercised
Option Pricing Models • Black – Scholes Best for European options pricing • Binomial (Cox Ross) Best for American options pricing
Option Pricing Models • Many variations of these models exist • Their outputs can vary • Usually caused by dividend valuations • Worrying about these differences is a waste of time for the typical investor
Option Pricing Models • Listed options trading begins in April 1973 • In 1973 a 5 function calculator cost $300 • In 1973 a year’s tuition at The University of Illinois cost about $800
Price Movements Theoretical Values Change because Options Exist in a dynamic environment… • Stock Prices Change • Time Goes By • Interest Rates are Adjusted • Volatility Increases and Decreases
Option Pricing Models • Pricing models also output a series of GREEKS The importance of the GREEKS Setting expectations Selecting strike prices Selecting expirations Managing position risk
Option Evaluation UNDERSTANDING: DELTA GAMMA THETA RHO VEGA
DELTA • RATE OF CHANGE IN THE OPTION PRICE FOR A CHANGE IN THE UNDERLYING SECURITY • Calls have positive DELTA • Puts have negative Delta
DELTA • ATM Call will have about .50 Delta or be referred to as 50 Deltas • OTM Call will have a lower Delta something like .15 or .20 • ITM Call will have a higher Delta something like .70 or .80
Delta • Call options have positive Delta – positive correlation to stock price change • Put options have negative Delta – negative correlation to price change
Delta • A Put/Call pair will have a total Delta with an absolute value of 1.00 • Stock price $52.00 $50 Call Delta of .57 $50 Put Delta of -.43
DELTA • Is not constant • As options move more in the money delta increases • As options move more out of the money delta declines
DELTA • Changes as time passes • May change with changes in volatility
GAMMA • THE RATE AT WHICH DELTA CHANGES FOR A CHANGE IN THE PRICE OF THE UNDERLYING SECURITY • GAMMA IS WHAT OPTIONS BUYERS ARE “PAYING” FOR
GAMMA • An ATM option is about 50 delta – 10 gamma • 50 shares of stock is 50 delta • The ATM option auto-adjusts as the stock price changes, time passes or volatility changes – delta goes to 60 for a +$1 move • 50 shares of stock is 50 delta
THETA • THE CHANGE IN THE PRICE OF AN OPTION FOR A CHANGE IN THE TIME TO EXPIRATION • The daily rent buyers pay • The daily rent sellers receive
RHO • CHANGE IN THE VALUE OF AN OPTION FOR A CHANGE IN THE INTEREST RATE/DIVIDEND CALCULATION • Not a big deal for most users as the impact is small • Becomes a big deal in the calculation of LEAP option positions
RHO • Changes in interest rates have a very small impact on short dated option values • Changes in interest rates may have a large impact on stock values • Generally the impact on stock values is more important to the option pricing than the interest rate change
RHO • Reality check ATM $50 Call Fed raises rates 1% Call price changes by .$02 RHO just isn’t a big deal
VEGA (kappa or omega) • CHANGE IN THE VALUE OF AN OPTION FOR A CHANGE IN THE VOLATILITY ASSUMPTION • Different for different strikes and expirations • Biggest impact on short term OTM options
VEGA • A well informed option user needs to have a good working understanding of this GREEK • Earlier Volatility webinar archived in our education section at www.iseoptions.com • Best to think about VEGA in percentage impact
Benefits Of Trading At ISE • Largest equity options market • First and proven all-electronic platform in the US • Spreads traded as spreads • Electronic buy/write capability
www.iseoptions.com • Free volatility data on all ISE-listed options • Updates on ISE broad market index products • Updates on ISE sector index options