9 out of 10 derivative traders have heard about Option Greeks, but only a few are aware how these can be applied in real market. What is more important, most are not aware of the immense power of the option Greeks and what they can do for you. In today’s article, we shall talk about what these Greek letters mean and how they can help traders unleash their edge by evaluating the option premium at any given time.
Advantage of Option Greeks
We all know that option greeks are the building blocks of the derivatives market. This is primarily how Institutional Traders successfully capture sensitive information like the long term trend or the short swings way ahead of time. At a retail level, understanding the greeks can help derivatives traders gain 6 powerful advantage.
- Catch the direction of the market with high accuracy.
- Spot the strikes you must trade.
- Understand when these strikes must be traded.
- Identify whether an option strike will expire in the money.
- Intelligently adjust the Delta drift with respect to the shift in the underlying.
- Spot how sensitive options are visa-vis the implied volatility.
How To Use The Greeks
Option Greeks, including Delta, Gamma, Theta, Vega and Rho, are the different factors that cause the price of a derivate instrument to change. These are very similar to the human DNA structure and can be used to locate the price of an instrument at time “t”. Understand that, in option trading the time “t” and “σ” are of utmost importance. Now let us look at the practical side of markets. We all know that markets react to news and events. The important question is, can we predict these events? The answer is a “Big No”.
Since there are various external factors that impact the market, it is practically impossible for an individual trader to predict those events. However, it is absolutely possible to design a greek based pricing model to trade the weekly and monthly options contracts.
Retail traders can use these pricing models to determine the impact of each external factor even before the event triggers a shift in the implied volatility of the option strike. Take for example; we all know that an option strike maintains a constant elasticity with respect to the variance of the underlying. The idea here is to design a model which returns the fair value of the option strike with respect to the covariance between gamma and vega when the event is underway. This will help you determine how much the option will move when the implied volatility changes due an event like the recent tax cut by Nirmala Sitharaman. We know that theta decay speeds up as an option gets closer to the expiry, so we can use this concept to adjust the time decay with the constant elasticity model, regardless of the nature of the event.
Now, let us discuss a real model that is used by Fund Houses. In this model, the “Forward Implied Volatility” is calculated based on 5 different spreads at t1, t2, t3, t4, t5. The rationale behind this model is that the firm must have a fixed rate of return regardless of the market volatility and the theta decay. Thus the position of the firm continues to drift alongside the constant variance in the market elasticity. When the price of the instrument drops, the profitability might expand depending on the deviation of the “FIV” from the sigma. The beauty of such a trading model is you are least bothered about the market volatility. This is an intelligent way to stay ahead of the curve, simply because you incorporate the fact that implied volatility is a variable, not a constant.