Option Greeks and Implied Volatility

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There are many reasons why an investor or trader trades options. The main reasons, as with other derivatives markets, is to hedge another position or to speculate on the performance of the underlying security.

1) Hedging: A hedge is like an insurance policy in that it can help mitigate risk for a small fee. For example, a portfolio manager buys a large position in Company A stock for its long-term price appreciation potential but is worried that the next earnings report will show short-term issues. He or she can buy put options on that stock that will increase in value if the price of the stock falls on its earnings news.
2) Speculation: Options allow both buyers and sellers to capitalize on their market forecasts, whether they are bullish , bearish , or neutral. However, because options prices depend on many factors, including market volatility , traders can profit from increases or decreases in those factors as well.

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While traders can look at individual options data, a very widely used display called an “options chain” lists all options, or a subset, available for a given expiration month. Options traders also look at derivatives of the price that measure how fast their prices decay over time, how fast their prices change with a given change in the price of the underlying, and more. These derivatives are designates with Greek letters such as delta and gamma, so traders call them “the Greeks”.

I. Delta – measures how much an option price changes for a one-point move in the underlying. Its value ranges between 0 and 1 for calls and between -1 and 0 for puts.
II. Gamma – measures the rate of change in delta. It is essentially the second derivative of price.
III. Vega – measures the risk from changes in implied volatility . Higher vol makes options more expensive since there is a greater change than the underlying security price will move above the strike price for a call.
IV. Theta – measures the rate of time-value decay and is always a negative number as time moves in only one direction.
V. Rho – measures the impact of changes in interest rates on an option’s price.

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Implied volatility (IV) is the estimated volatility of a security’s price and is critical in the pricing of options. Although not a guarantee, implied volatility tends to increase while the market in the underlying security is bearish . Conversely, when the underlying security is bullish , implied volatility tends to decrease. This is due to the common belief that bear markets are riskier than bull markets.

The most important is that implied volatility is an estimate of the future volatility , or fluctuations, of a security’s price. While levels of implied volatility are associated with bullish and bearish markets in the underlying security, it really does not predict market direction. It only forecasts the sizes of potential price swings. Implied volatility is not the same as historical volatility , also known as realized volatility or actual volatility . Historical volatility measures past market changes in the price of the underlying asset.

Trade with care.
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