Tag: forensics

Forensics: NIFTY Options – Implied Volatility(IV)

Implied volatility(IV) is a measure of the market’s expectations for the underlying’s performance during the life span of the option.

The IV of an option is actually backed out of the price of the option. All the inputs of an options pricing model are known (time to expiration, strike, price, interest rates) except for the volatility that the option is pricing in. So that value can be backed out and allows you to understand the relative value of the option’s price.

This Khan Academy video does a good job of explaining what IV is:


 

  • When IV is high, options will be more expensive to purchase. And low IV will translate to more affordable option prices.
  • Heightened implied volatility correlates with bearish sentiment, while low IV suggests a bullish mood.
  • If you purchase an option with high IV, you need a much bigger move out of the underlying stock to profit from the trade.
  • IV will rise ahead of scheduled events, such as earnings reports and new product launches. Once the anticipated event occurs, IV will immediately drop.

IV in Action: March 2014 NIFTY Options Since Jan

First, lets look at the underlying:

NIFTY

To capture the full move of the NIFTY, you’ll have to look at, at least, a dozen strikes between 5950 and 6900.

IV of calls:
March 2014 NIFTY IV (CE)
IV of puts:
March 2014 NIFTY IV (PE)
 

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Forensics: NIFTY Options – Vega(κ)

Vega(κ) is the sensitivity of an option’s value to underlying volatility(σ). σ is one of the main drivers of change in an option’s value and so κ allows you to quantify this particular risk.

For example, a κ of 1178.50 when the model price is Rs.188.92 and σ is 0.185 implies that if σ rises by 1% to 0.195, then the price will increase to Rs.188.92 + 1178.50/100 = Rs.200.705

  • κ increases as volatility increases
  • κ for a long term option is higher than the κ for a shorter term option with the same strike
  • an at-the-money option will have a greater κ than either an in-the-money option or an out-of-the-money option
  • κ is the same value for calls and puts

Vega in action: March 2014 NIFTY Options since Jan

First, lets look at the underlying:

NIFTY

To capture the full move of the NIFTY, you’ll have to look at, at least, a dozen strikes between 5950 and 6900.

κ:

March 2014 NIFTY Vega

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Forensics: NIFTY Options – Gamma(γ)

The option’s gamma(γ) is a measure of the rate of change of its delta(δ). δ is dynamic: it changes not only as the underlying stock moves, but as expiration approaches. γ is the Greek that determines the amount of that movement.

  • γ is the amount a theoretical δ will change for a corresponding one-point change in the price of the underlying.
  • γ will be a number anywhere from 0 to 1.00 and is positive when buying options and negative when selling them.
  • Deep-in-the-money or far-out-of-the-money options have lower γ than at-the-money options.
  • As implied volatility decreases, γ of at-the-money calls and puts increases.
  • When implied volatility goes higher, the γ of both in-the-money and out-of-the-money calls and puts will be decreasing.
  • As the time to expiration draws nearer, the γ of at-the-money options increases while the γ of in-the-money and out-of-the-money options decreases.

Gamma in Action: March 2014 NIFTY Options Since Jan

First, lets look at the underlying:

NIFTY

To capture the full move of the NIFTY, you’ll have to look at, at least, a dozen strikes between 5950 and 6900.

γ:

March 2014 NIFTY Gamma

Note that the γ value is the same for calls as for puts. Some intuitions:

  1. The δ tells us how many underlying contracts we are long/short.
  2. The γ tells us how fast our “effective” underlying position will change.
  3. So γ shows how volatile an option is relative to movements in the underlying asset.
  4. γ will let you know how large your δ (position risk) changes.

Source:
Option Gamma
Gamma
 

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Forensics: NIFTY Options – Delta(δ)

Delta(δ) is a theoretical estimate of how much an option’s premium may change given a 1-point move in the underlying. For an option with a δ of .50, an investor can expect about a 50p move in that option’s premium given a Rs.1 move, up or down, in the underlying.

  • For purchased options owned by an investor, δ is between 0 and 1.00 for calls and 0 and -1.00 for puts.
  • As a call option goes deeper-in-the-money, δ approaches 1.00 on the increased likelihood the option will be in-the-money at expiration.
  • With an increase in implied volatility, δ gravitates toward .50 as more and more strikes are now considered possibilities for winding up in-the-money because of the perceived potential for movement in the underlying.
  • Low implied volatility stocks will tend to have higher δ for the in-the-money options and lower δ for out-of-the-money options.
  • At expiration an option either has a δ of either 0 or 1.00 with no time premium remaining.
  • As expiration nears, in-the-money call δs increase toward 1.00, at-the-money call δs remain around .50 and out-of-the-money call δs fall toward 0 provided other inputs remain constant.

Delta in action: March 2014 NIFTY Options Since Jan

First, lets look at the underlying:

NIFTY

To capture the full move of the NIFTY, you’ll have to look at, at least, a dozen strikes between 5950 and 6900.

δ of calls:

March 2014 NIFTY Delta (CE)

δ of puts:

March 2014 NIFTY Delta (PE)
 

Note how δs rip towards 0 or 1 as expiry approaches? Here’s an important intuition: in-the-money options will move more than out-of-the-money options, and short-term options will react more than longer-term options to the same price change in the stock.

Source: Understanding Delta

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Forensics: NIFTY Options – Theta(θ) Decay

The most intuitive option greek is theta (θ) – a measurement of the option’s time decay. Theta measures the rate at which options lose their time value, as the expiration date draws nearer. It is usually expressed as a negative number.

Simply put, theta of an option reflects the amount by which the option’s value will decrease every day.

Time and Theta

  1. Longer term options have theta of almost 0 as they do not lose value on a daily basis.
  2. Theta is higher for shorter term options.
  3. Theta is higher for at-the-money options.
  4. Theta changes at an exponential rate. It goes up dramatically as options near expiration as time decay is at its greatest during that period.

Theta decay in action: March 2014 NIFTY Options Since Jan

First, lets look at the underlying:

NIFTY

To capture the full move of the NIFTY, you’ll have to look at, at least, a dozen strikes between 5950 and 6900.

θ of Calls:

March 2014 NIFTY Theta (CE)

θ of Puts:

March 2014 NIFTY Theta (PE)

Does it mean that you should go out and sell the heck out of every option you can find close to expiry?
 
No! As expiration gets closer, the risk posed by extreme amounts of gamma outweighs the theta you’re collecting.
 
Stay tuned for more.
 

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