Chapter 10: How to Use Options Greeks to Trade Better?
Options trading can be a powerful tool to manage risk, enhance returns, or speculate on market movements.
However, to become a successful options trader, it’s essential to grasp the concept of “Options Greeks.”
These Greek letters represent a set of metrics that help traders better understand and manage their positions.
In this Chapter, we will break down what Options Greeks are and how they can be used to trade options more effectively.
What are Options Greeks?
Options Greeks are a group of risk metrics that quantify various aspects of an options contract.
They help traders evaluate and predict potential changes in an option’s price with factors such as underlying asset price movements, time decay, implied volatility changes, and interest rates.
Each Greek letter corresponds to a different aspect of options pricing and risk management:
- Delta
- Gamma
- Theta
- Vega
- Rho
1. Delta
Delta measures how much an option’s price will change in response to a 1 Rupee change in the underlying asset’s price.
Put options have negative delta whereas call options have positive delta and It ranges from -1 to 1 for put and call options, respectively.
A higher delta means the option’s price moves more closely in line with the underlying asset.
For example, if you have a call option with a delta of 0.70 and the underlying stock increases by Rs. 10, the option’s price would rise by ~ 7 rupees.
2. Gamma
Gamma measures the rate of change of an option’s delta concerning changes in the underlying asset’s price.
It tells you how delta itself changes as the stock price moves. Gamma is highest for options that are near the money and close to expiration.
For example, if your option has a gamma of 0.05, its delta will change by 0.05 for every 1 rupee move in the underlying asset’s price.
3. Theta
Theta quantifies the rate at which an option’s value decreases with the passage of time, also known as time decay.
It’s particularly crucial for traders holding options contracts, as time decay can erode the value of the option.
For example, if your option has a theta of -0.50, its value will decrease by Rupees 0.50 (50 paise) per day, all else being equal.
4. Vega
Vega measures how much an option’s price will change for each percentage point change in implied volatility.
It reflects sensitivity to changes in market sentiment and can be crucial during volatile times.
For example, if your option has a vega of 0.5, it should increase by Rupees 0.50 (50 paise) for every 1% increase in implied volatility.
5. Rho
Rho indicates how much an option’s price will change for a 1% change in interest rates.
This Greek is less critical for short-term traders but can be relevant for longer-term options.
For example, if your option has a rho of 0.05, its price should increase by 0.05 rupees Or 5 paise for every 1% increase in interest rates.
How Can Options Greeks Help in Options Trading?
One can argue over the fact that option Greeks are quite different in theory than in practice.
However, it’s really important to understand these concepts in theory and then apply the logic behind these concepts to improve your trading.
Having said that, option Greeks can have multiple applications and can be used to design various option trading strategies too.
The most common usecase by understanding and applying Options Greeks like Delta and Gamma is – you may be able to protect your portfolio during a market downturn and capitalize on the changing dynamics to enhance your hedging strategy.
Here are some examples on how each one can be used to enhance your options trading strategies:
1. Delta for Directional Trading Or Option Selling
Delta can help you select options that match your market outlook. For bullish views, choose call options with high positive delta values. For bearish views, select put options with high negative delta values.
You also need to keep in mind that higher delta values could have higher fluctuations in your MTMs.
If the underlying asset is volatile, the higher delta value option premiums will also be volatile compared to the lower delta options.
So it’s important to choose a right strike price which is aligned to your risk reward matrix.
Delta can also help you in strike selection. For example, if you are an option writer, selling call or put options but your strategy is designed to handle minimum risk, then you might want to sell OTM options with lower delta values.
That’s because there is lesser volatility and thus, you could have a higher probability of making profits in your strategy versus selling higher delta value options.
Options with higher delta values indicate that the option’s price is more sensitive to changes in the underlying asset’s price, meaning it will move more in sync with the stock’s movements.
2. Gamma for Risk Management
Gamma is crucial for managing your delta risk. If you want to keep a specific delta, you’ll need to adjust your position regularly as gamma changes. This is especially important when hedging or managing a portfolio of options.
For example, if you know the gamma values of your positions, it’s easier to predict how fast the option prices can move incase of a sharp move in the prices of the underlying asset
3. Theta for Time Decay Strategies
Theta can guide you in selecting the right time horizon for your trades.
If you’re trading options with limited time to expiration, you need to be aware of theta’s impact.
Options with high theta can be suitable for short-term trades, while those with low theta might be better for longer-term strategies.
4. Vega for Volatility Trading
Vega can help you gauge market sentiment and adapt your strategy accordingly.** In times of expected volatility, you might favour options with higher vega to capitalise on potential price swings.
5. Rho for Interest Rate Sensitivity
Rho is most relevant when interest rates are expected to change significantly. If you anticipate interest rate movements, consider options with higher rho values to potentially benefit from these rate changes.
Let’s put it all together in an example
Option Greeks in Practice
Successful options trading involves a combination of these Greeks, depending on your strategy and market conditions.
Let’s explore another example of how to use Options Greeks to trade better. Imagine you’re a trader expecting high volatility in Bajaj Finance stock due to an upcoming earnings report.
This quarter has been good for the company and you are expecting that the results to be exceptionally good. The CMP of Bajaj Finance is 7400 and you are expecting a sharp move in the coming days before the quarterly results.
To navigate this, you analyze the Options Greeks.
1. Using Delta for Guidance
By looking at the option strikes available, you plan to choose a call option having a Delta of 0.70.
This implies that for every 10 Rupee increase in the stock, your option’s value should go up by around 7 Rupee.
Thus, it aligns with your bullish outlook as if the spot price of the stock will see a spike, the option you choose will see some great momentum.
2. Analysing Option Time Sensitivity by Theta
Recognizing that Theta of the same call option -0.03, and you are okay with this theta since you are anyway expecting some momentum in the shorter term.
A higher theta value would mean that time decay may impact your option premium prices in case there is no momentum during the holding period.
But in our case, since we are banking on the price of Bajaj finance to increase quickly (within some days), the above theta value seems fair to us and probably your call option will be less impacted by time decay.
3. Gauging Volatility with Vega
Seeing a Vega of 0.15, you anticipate a potential spike in implied volatility around the earnings report. This insight encourages you to hold onto the option, expecting an increase in its value.
4. Hedging with Gamma
Later, the stock starts moving. Keeping the Gamma of 0.07 in mind , you adjust your position as the stock price shifts. This helps maintain your desired Delta, preventing overexposure.
By incorporating Options Greeks into your strategy, you’ve strategically chosen an option that aligns with your outlook and risk tolerance.
As the stock behaves, you use Gamma to fine-tune your position, maximizing potential gains while managing risk.
This example showcases how traders use Options Greeks to make informed decisions and adapt to market dynamics.