Conclusion: Volatility and the Greeks

Conclusion: Volatility and the Greeks

This course covered volatility, both historical and implied, as well as the option Greeks. When we started, our objective for you was to be able to understand the answers to the following questions:

• How are options priced? To buy low and sell high, you need to understand how to “spot a deal”.
• What happens to option prices if things change like the underlying stock price or time?

By now, you should know that an options price is derived from the underlying price, the strike price which is relative to the current underlying price, time until expiry, implied volatility, and the interest rate. To understand if you are getting a good deal – if a contract is oversold – you can look to the implied volatility. Since implied volatility is just a single number and indices and stocks all have their own volatility specific to them, you can use the underlying security’s historical volatility as a benchmark. With historical volatility, you can see if the implied (or future) volatility is higher or lower than recent historical (or realized) values. Of course, this is merely a simple way of identifying if volatility is too high or too low. In subsequent courses, we will discuss other approaches like implied volatility ranking (IVR), implied volatility percentile (IVP), as well as volatility modeling.

We also introduced the Greeks which provide traders with information about how the option price changes based on other factors changing. Delta gives us insight into how much the option price will change if the underlying price goes up or down. Gamma is a derivative of delta and tells traders how much the delta will change as the underlying price goes up or down. Theta warns us about the impact of time decay and how much value an option contract will lose if you hold it for one more day. Vega is associated with implied volatility and tells you the impact of the option’s price based on changes in volatility. Lastly, Rho is the interest rate sensitivity of the option and it lets us know how much the option price will go up or down based on changes in the interest rate.

With the Greeks, we can be more knowledgeable traders about the potential risks and rewards of entering into a potential contract. A concept that we haven’t discussed is the “portfolio” of Greeks. For example, if you buy a call option, you will have positive delta exposure. If you also sell a call option, you will have negative delta exposure on this short call. When you sum the positive and negative delta, you will have a net delta value. It could be positive or negative depending on the strikes chosen for the long and short call option. Regardless, the net delta will be smaller than the individual positions. Perhaps you are worried about having too much exposure to theta. A way to reduce that would be to have an offsetting position that reduces theta on a portfolio level.

This idea of executing multiple option trades is known as an option strategy. Our next course will dive into multi-contract, also known as multi-leg, option strategies. By adding long calls, long puts, short calls, and short puts together in various combinations, you can do more than simply make a directional bet on the underlying or collect premium. You can make a bet on increasing volatility, decreasing volatility, reduce the cost of a directional bet, or hedge premium collection.