What Option Greeks and Implied Volatility means

What Option Greeks and Implied Volatility means

If you have traded options before, or you if you intend on doing so, you must understand the forces and the primary factors that drive the Options Prices. Although the main force in the markets, as always, is the Demand, the other factors which affect the Option’s Price are The Greeks and the Implied Volatility, which will be explained here.

# The Greeks

Delta

How the option’s price will change with a $1 change in the stock price.

Call options have positive Deltas. Put options have negative Deltas.

For example:

NFLX stock is trading at $500.
Option Details:
Strike price: $600.
Delta: 0.5.
Expiration date: 10 days.
Option’s Price: $10.

The Option’s Delta of 0.5 means that for each $1 change in the NFLX stock, the option’s price would change by $0.5.

So if the NFLX stock gets to $601, the Option’s price will rise to $10.5.

Gamma

How an option’s Delta would change with a $1 change in the stock price.

Call deltas increase towards 1 when the stock increases and falls towards 0 when the stock decreases. For example:

NFLX stock is trading at $500.
Option Details:
Delta: 0.5
Gamma: 0.1
Option’s Price: $10.

If NFLX stock to rise to $501, then the option’s price would increase by the initial Delta of 0.5 to $10.5. Then, the Option’s Delta will be (0.5 + 0.1 Gamma) = 0.6.

If the stock price increases to $502, then the Option’s price increases by 0.6 to $11.1 (10.5 + 0.6).

For more information about Gamma, the “Gamma Effect” and how it affects the markets click here.

Theta

Estimates the option’s price decrease with the passing of one day. It is always negative because as an option gets closer to its expiration, its extrinsic value will get closer to zero.

# What Option’s Extrinsic Value is?

Extrinsic value is the premium of an option over its underlying stock’s price. If a call option has value when its underlying stock price is lower than the strike price, then all the option’s value consists of extrinsic value.

However, if a call option is In the Money; if it has a strike price of $100 and the stock is trading at $105, the option has $5 of intrinsic value. If the option trades at $6, then the extra $1 is extrinsic value.

Vega

Estimates how much the implied volatility would change with each change in the option’s price. Because the option’s price is determined by Demand, the following example will help you understand its meaning:

Option’s Price: $10
Vega: 0.1
Implied Volatility: 30%

If the Option’s price goes up by $0.1 (as the Vega), then the expected Implied Volatility would change and increase by 1% (while every other variable remains the same).

# Implied Volatility

Implied Volatility is one of the primary things to watch when looking at Options. The Implied Volatility is a measure to compare one stock’s option prices to another stock’s option prices.

Because Option Prices are determined by supply and demand, an increase in the Option’s Price will result in higher implied volatility which means larger expected movements in the stock’s price.

On the contrary, a decrease in the Option’s Price will result in lower implied volatility which means smaller expected movements in the stock’s price.

Implied Volatility is shown as an annualized percentage and represents the one standard range for a stock price. It reflects the price range the market anticipates for the underlying stock. What it actually means is that if:

Option’s strike price: $500
Implied Volatility: 50%

The market anticipates that the stock’s price will range between $250-$500-$750.

[ 50% * 500 = 250] => The range is between 500 – 250 = 250, and 500 + 250 = 750. => 250-500-750.

The Formula for the expected range for any time frame is:

Implied Volatility Formula

 

In sum, the Implied volatility represents the amount of extrinsic value that exists in the stock’s option relative to its time until the option expires.

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