Relationship between OPTIONS GREEK with DEGREE of MONEYNESS, IMPLIED VOLATILITY and TIME TO EXPIRATION: Summary � Part 1

Option Greeks have been one of the main topics that I have previously shared in details in this blog.
I�ve tried to explain each of option greek in a simple way for easy but yet deep understanding. It�s really not easy doing this, but I was very encouraged by many compliments and positive feedback from my readers. I'm happy that many people in fact have benefited from these Option Greeks articles. I'd really like to thank my readers for their continuous support. :)
Here I tried to summarize the main understanding of Options Greeks:

DELTA
Delta is an option greek that measures of the change in the option price due to a change in the underlying stock price.

Delta of ATM, ITM & OTM Options
The delta values for long position will be positive for Calls (0 to 1) & negative for Puts (0 to -1).
At-the-money (ATM) options have deltas around 0.5 (Calls: +0.5, Puts: -0.5).
Out-of-the-money (OTM) options have deltas between 0 to 0.5 (Calls: 0 to +0.5, Puts: 0 to -0.5).
In-the-money (OTM) options have deltas between 0.5 to 1 (Calls: +0.5 to +1, Puts: -0.5 to -1).

Effect of Time To Expiration on Delta:
As the time to expiration is nearing, the delta of ITM options increases (i.e. ITM option�s delta gets closer to 1 for Calls or to -1 for Puts) and the delta of OTM options decreases (i.e. OTM option�s delta gets closer to 0).

Impact of Implied Volatility on Delta:
When Implied Volatility (IV) increases, delta of OTM option will increase, whereas the delta of ITM option will decrease.
However, the delta of ATM option will always remain at around 0.5.

GAMMA
Gamma is an options greek that measures the rate of change of delta due to a one-point change in the price of the underlying stock.
In other words, Gamma estimates how much delta would change if the price of the underlying stock changes by $1.
So, gamma indicates how �stable� its corresponding delta is.
A high gamma means that the delta can change considerably for even a small move in the stock price.
Unlike delta, gamma for long position is always positive for both Calls and Puts. That means delta will increase as the underlying price increases, and delta will decrease as the underlying price decreases.

Gamma of ATM, ITM & OTM Options
Gamma is the largest for ATM options, and gradually decreases as it moves furthers towards ITM and OTM.
This means that the delta of ATM options changes the most when the stock price moves up or down, as compared to ITM & OTM options.

Effect of Time To Expiration on Gamma
As the time to expiration gets nearer, the gamma of ATM options increases (is relatively higher), whereas the gamma of deep ITM and deep OTM options normally decreases (is relatively lower).

Impact of Implied Volatility (IV) on Gamma
When the Implied Volatility decreases, the gamma of ATM options increases, whereas the gamma for deep ITM or OTM options decreases.
When the Implied Volatility is very low, the gamma of ATM options is relatively high, while the gamma for deep ITM / OTM options is relatively low (close to 0).
This is because when the volatility is low, the time value portion of an option is low. However, time value of ATM option is still higher relative to ITM & OTM options, hence the gamma of ATM option is higher as compared to ITM & OTM options.

On the other hand, when IV is high, gamma tends to be stable for ATM option as well as ITM and OTM options. This is because when volatility is high, the time value of deep ITM / OTM options are already quite substantial. As a result, the increase in the time value of deep ITM / OTM options as they go nearer the money will be less dramatic. Therefore, gamma tends to be stable across all strike prices in this case.

Continue to Part 2.

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* Options Trading Basic � Part 1
* Options Trading Basic � Part 2
* Understanding Implied Volatility (IV)
* Understanding Option�s Time Value
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* Learning Charts Patterns

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Option�s TIME VALUE � Putting It Together � Part 4: Behavior

The Behavior of Time Value
As mentioned in Part 3, the Time Value component of an option price will decline or �erode� as expiration is nearing (i.e. Time Decay).

The rate of decline of option�s time-value resulting from the passage of time (i.e. rate of Time Decay) is known as THETA, which is one of the Options Greeks.

Comparing Theta at a certain point of time between ATM (At-The-Money), ITM (In-The-Money) & OTM (Out-of-The-Money) options, Theta is typically highest for ATM options, and gradually decreases as options move towards ITM and OTM.
This is understandable because ATM options have the highest time value component, so they have more time value to lose over time than an ITM or OTM option.

Comparing Theta over time, there are different behaviors between ATM and ITM / OTM options:
For ATM options, as the Time Value component of an option price decreases when the option is approaching expiration, the rate of time value decrease is accelerating (i.e. Theta is increasing) as it is getting closer to expiration.
This means that the amount of time value disappearing from the option price per day gets bigger with each passing day. For ATM option, time value decreases sharply particularly in the last 30 days before expiration.

On the other hand, for both ITM & OTM options, Time Value actually decreases at a decelerating rate as expiration nears. In other words, Theta decreases as the option is approaching expiration.
This means that the amount of time value disappearing from the option price per day gets smaller with each passing day.

This Time Value behavior can be seen in the following graphs:

1) Time Value of ATM Option:






2) Time Value of OTM Option:




Note: Both pictures courtesy of Sigma Options

Therefore, based on the above, we can summarize as follow:

For ATM options, Theta (i.e. the rate of time value decline as the time passes) is typically the highest (as compared to ITM & OTM options), and will be increasing (i.e. the rate of time value decrease is accelerating) as the option is nearing expiration.

For both ITM & OTM options, Theta is relatively lower (than ATM options), and will be decreasing (i.e. the rate of time value decrease is decelerating) as the option is nearing expiration.

The Impact of Implied Volatility (IV) on THETA
Theta will also be affected by the changes in Implied Volatility (IV).
When IV decreases, Theta will be higher, particularly when it is nearing to expiration.
On the other hand, when IV increases, Theta would be lower.

Why is it so?
As previously discussed in Part 1, the level of Time Value of an option could basically be associated with the level of uncertainty as to whether or not an option can finish ITM.
The more uncertain as to whether an option can or cannot finish ITM before or at expiration, the higher the time value will be.

When Implied Volatility decreases and the option is nearing to expiration, such uncertainty will be lower.
Since Theta is the rate of time decay, when IV decreases, Theta will be higher (i.e. the rate of time value decrease due to the passage of time will be faster).
This is because higher Theta would consequently result in lower time value, which reflects the lower level of uncertainty due to lower Implied Volatility.
And this is particularly so when the expiration is nearing, because the underlying stock price will have lesser time to move, and therefore have even lower probability to finish ITM (i.e. even lower level of uncertainty).

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Option�s TIME VALUE � Putting It Together � Part 3: Main Factors � Implied Volatility & Time to Expiration

Go back to Part 2: Main Factors � 1) Degree of Options Moneyness

2) Implied Volatility (IV)
The higher the IV, the higher the option�s time value.

Why is it so?
Because higher IV reflects a greater expected fluctuation (in either direction) of the underlying stock price (e.g. due to earnings announcement is nearing, pending for FDA approvals, or some other important event / news, which is expected to move the stock price drastically).
Therefore, when IV is higher, the options would be more uncertain as to whether or not the options can finish ITM. This explains the higher time value.

3) Time Remaining to Expiration
The longer the time remaining to expiration, the higher the option�s time value.
Hence, all other things being equal, an option with more days to expiration will have more time value than an option with fewer days to expiration.

Why is it so?
Because the longer the time remaining to expiration, the underlying stock price would have more time to fluctuate, resulting in more uncertainty as to whether or not the options can finish ITM, and therefore the higher the time value.

As the option is approaching expiration, assuming all other things constant, the level of uncertainty will decrease, because the underlying stock price will have lesser time to move. Hence, the time value will decrease as the time to expiration gets shorter.

In general, for both Calls & Puts, as expiration is nearing, the Time Value component of an option price decreases or �erodes�. This is often called �Time Decay�.

Continue to Part 4: Behavior of Time Value

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* Options Trading Basic � Part 2
* Understanding Implied Volatility (IV)
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Option�s TIME VALUE � Putting It Together � Part 2: Main Factors � Degree of Options Moneyness

Go back to Part 1: Understanding What Time Value is.

MAIN FACTORS THAT AFFECT OPTION'S TIME VALUE
As discussed in the previous post, Time Value of an option will be mainly affected by:
1) Degree of Options Moneyness
2) Implied Volatility (IV)
3) Time Remaining to Expiration

Let�s see how all these factors affecting Time Value can be explained by �the level of uncertainty as to whether or not an option can finish ITM�.

1) Degree of Options Moneyness
As discussed in this post, Options Moneyness describes the relationship between an option�s Strike Price with stock price (i.e. where the Option�s Strike Price is in relation to the current stock price).

The farther the Option�s Strike Price to current stock price, the lower the time value will be.
Therefore, since for ATM options, the option�s Strike Price is the same as the current stock price, ATM options would consequently have the highest time value.
The time value will gradually decline as it moves to deeper ITM and deeper OTM options (like inverted-U curve), because the deeper ITM or OTM an option, the farther its Strike Price from the current stock price.

Why is it so?
Because ATM or near ATM options would have a higher uncertainty level as to whether or not the options can finish ITM, as compared to OTM & ITM options do.
This uncertainty level can be explained by the how far an option�s strike price from the current stock price (i.e. degree of Options Moneyness).

For OTM options:
The farther the option�s Strike Price from current stock price is (i.e. deeper OTM options), the more likely / higher probability that the OTM option cannot become ITM before or at expiration.
Since it has �higher probability� that the deeper OTM options cannot finish ITM (or �lower probability� that the deeper OTM options can finish ITM), that means the options would have �lower level of uncertainty� as to whether or not it can finish ITM.
This explains why deeper OTM options, the lower the option�s time value.

For ITM options:
The farther the option�s Strike Price from current stock price is (i.e. deeper ITM options), the more likely / high probability that the ITM option can become ITM before or at expiration.
Since it has �higher probability� that the deeper ITM options can finish ITM (or �lower probability� that the deeper ITM options cannot finish ITM), that means the options would have �lower level of uncertainty� as to whether or not it can finish ITM.
This explains why deeper ITM options, the lower the option�s time value.

For ATM or near ATM options:
As the option�s Strike Price is equal to or near current stock price, it is still very uncertain if the option can or cannot become ITM before or at expiration.
In other words, ATM or near ATM options have �higher level of uncertainty� as to whether the options can or cannot finish ITM. As a result, their time value will be higher.



Continue to Part 3: Main Factors � Implied Volatility & Time to Expiration.

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Option�s TIME VALUE � Putting It Together � Part 1: Understanding What It Is

As mentioned in �Option Price Components�, option price or premium consists of:

For ITM Option:
Option Price = Intrinsic Value + Time Value

For ATM and OTM Options:
Option Price = Time Value

Whereas:

Intrinsic Value of ITM CALL Option:
Intrinsic Value = Current Stock Price � Strike Price.

Intrinsic Value of ITM PUT Option:
Intrinsic Value = Strike Price � Current Stock Price.

As can be seen in the above formula, it is only ITM options that have Intrinsic Value component, whose value is simply the difference between option�s strike price and current stock price.
Whereas for ATM & OTM options, Time Value is the only component of the options� price / premium.

What Is Option�s Time Value?

As mentioned in the previous post - More Understanding about Options Time Value:

Time value can be viewed as �the price that people are willing to pay for the chance / uncertainty as to whether or not an option will finish In-The-Money (ITM)�.
The more uncertain, the higher the time value will be.

In other words, the level of Time Value of an option could basically be associated with the level of uncertainty as to whether or not an option can finish ITM.
The more uncertain as to whether an option can or cannot finish ITM before or at expiration, the higher the time value will be.
When it is more certain that an option can or cannot finish ITM, the time value will be lower.
In other words, when an option has �higher or lower probability� that it can or cannot become ITM before or at expiration, that means the �level of uncertainty� will be lower.
So, it is the level of uncertainty that matters, not whether it has higher or lower probability to finish ITM or not finish ITM.

In the next post, we�ll discuss further with more elaboration and examples about how this �level of uncertainty� could explain option�s time value.

Continue to Part 2: Main Factors that Affect Option�s Time Value.

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Main Factors that Affect Option�s TIME VALUE

As mentioned in �Option Price Components�, option price or premium consists of:

For ITM Option:
Option Price = Intrinsic Value + Time Value

For ATM and OTM Options:
Option Price = Time Value

Whereas:

Intrinsic Value of ITM CALL Option:
Intrinsic Value = Current Stock Price � Strike Price.

Intrinsic Value of ITM PUT Option:
Intrinsic Value = Strike Price � Current Stock Price.

As you can see from the above formula, Intrinsic Value of an option is very straightforward.
It�s simply the difference between option�s strike price and current stock price.
Time Value component of an option is the one that make an option very complicated to understand.

Time Value of an option would be mainly affected by:

1) Degree of Options Moneyness
As discussed in this post, Options Moneyness describes the relationship between an option�s Strike Price with stock price (i.e. where the Option�s Strike Price is in relation to the current stock price).

The farther the option�s Strike Price to current stock price, the lower the time value will be.
Therefore, since for ATM options, the option�s Strike Price is the same as the current stock price, ATM options would consequently have the highest time value.
The time value will gradually decline as it moves to deeper ITM and deeper OTM options (like inverted-U curve), because the deeper ITM or OTM an option, the farther its Strike Price from the current stock price.

2) Implied Volatility (IV)
The higher the IV, the higher the option�s time value.

3) Time Remaining to Expiration
The longer the time remaining to expiration, the higher the option�s time value.
All other things being equal, an option with more days to expiration will have more time value than an option with fewer days to expiration.

Hence, Implied Volatility (IV) is not the only one that influences an option�s time value. That�s why although, for instance, IV of an option is very much higher than the other options, it does not mean that its premium will be higher in terms of dollar value. There are other factors affecting their overall premium.

Just remember that whether an option is considered �cheap� or �expensive�, it is not based on the absolute dollar value of the option, but instead based on its IV.
When the IV is relatively high, that means the option is considered �expensive�.
On the other hand, when the IV is relatively low, the option is considered �cheap�.
(Please see this post � How To Determine If An Option Is Cheap (Underpriced) Or Expensive (Overpriced) � for further discussion).

However, the overall option price / premium in absolute dollar value will be determined by other factors as discussed above.
Therefore, it�s possible that an option is low in terms of dollar value, but it�s considered �expensive� due to relatively high IV.
On the other hand, an option can be high in terms of dollar value, but it�s considered �cheap� due to relatively low IV.

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The Impact of IMPLIED VOLATILITY (IV) on OPTIONS GREEKS: Summary

The Impact of Implied Volatility (IV) on DELTA
Assuming all other factors constant, when Implied Volatility increases, the time value portion of an option will increase.
As a result, the delta of OTM (Out-of-The-Money) options will go up, whereas the delta of ITM (In-The-Money) options will go down.
Nevertheless, the delta of ATM (At-The-Money) options will always remain at around 0.5.

Why is it so?
As discussed previously, IV has a very big impact on the option price. However, IV would affect only the time value component of an option's price, not on the Intrinsic Value.
Therefore, when there is significant movement in Implied Volatility, ATM and OTM options will be greatly affected as compared to ITM options.

However, although ATM will be significantly affected by IV movement, the delta of ATM options will always be around 0.5.

The Effect of Implied Volatility (IV) on THETA
When Implied Volatility (IV) decreases, Theta will be lower, especially when it is approaching expiration.
On the other hand, when IV increases, Theta would be higher.

Why is it so?
As discussed earlier in this post, Time Value as the price that people are willing to pay for the chance / uncertainty as to whether or not an option will finish ITM.
The more uncertain, the higher the time value will be.
An option that is far OTM has almost no chance of finishing ITM. As such, it will not command a high time value.
An option that is already deep ITM is almost certain that it will finish ITM, hence time value is smaller.
But ATM or near ATM options have more uncertainty as to whether or not the options will finish ITM, and therefore these options have a higher time value.

When IV decreases, such uncertainty will be lower, particularly when the option is nearing to expiration. This lower uncertainty will then be reflected in lower time value. Since Theta is the decrease of time value due to the passage of time, Theta will naturally be lower because it has less time value to lose over the remaining time to expiration.

For more detailed discussion, go to: Options Greek.

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The Impacts of TIME REMAINING TO EXPIRATION on OPTIONS GREEKS: Summary

The Effect of Time Remaining To Expiration on DELTA
Delta is a measure of the change in the option price resulting from a change in the underlying stock price.

An option�s Delta does change as one trading day passes. This is often called as �Delta Decay�.
As the expiration is nearing (time to expiration gets shorter), the time value portion of an option is declining (time decay effect).
This causes the delta of ITM (In-The-Money) options to increase (i.e. ITM option�s delta gets closer to 1 for Calls or to -1 for Puts) and the delta of OTM (Out-of-The-Money) options to decrease (i.e. OTM option�s delta gets closer to 0).

As a result:
For ITM options, for the same strike price, the longer days to expiration, the lower the delta. Hence, a next month ITM option will have a lower delta than the current month option.
On the other hand, for OTM options, for the same strike price, the longer days to expiration, the higher the delta. So, a next month OTM option will have higher delta than the current month option.

The Impact of Time Remaining to Expiration on THETA
As mentioned earlier, as the expiration is nearing (fewer days to expiration), the time value portion of an option will be declining due to �time decay� effect.
And Theta is a measure of the Time Decay, i.e. the rate of decline of option�s time-value resulting from the passage of time.

Theta (time decay) increases as an option gets closer to expiration.
Theta would increase sharply (resulting in time value decrease at an accelerating rate) in the last few weeks before expiration (particularly in the last 30 days before expiration). Therefore, this can severely undermine a long option holder's position.

However, please note here that Theta increase sharply (Time Value decreases at accelerating rate) as expiration nears is true only for ATM option.

For both ITM & OTM options, on the other hand, Theta decreases as an option is approaching expiration.
As a result, for both ITM & OTM options, Time Value actually decreases at a decelerating rate as expiration nears.


Please refer to �More Understanding about Options Time Value� for further discussion about this.

The Effect of Time Remaining to Expiration on VEGA
Vega is a measure the sensitivity of an option�s price to changes in Implied Volatility (IV).
Assuming all other things unchanged, Vega decrease as an option gets closer to expiration.

Vega is higher when there is more time remaining to expiration. This makes sense because options with more time remaining to expiration have larger portion of time value, and it is the time value that is affected by changes in volatility.

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Options Greeks and Position in the Market (Long vs. Short): Summary

DELTA and the position in the market:
* Long calls have positive delta; short calls have negative delta.
* Long puts have negative delta; short puts have positive delta.
* Long stock has positive delta; short stock has negative delta.

Positive delta means that the option�s value will increase when the underlying stock price increases, and will decrease when the stock price decreases (positive relationship).
Negative delta means that the option�s value will increase when the underlying stock price drop, and will decrease when the stock price rises (negative relationship).

For Calls, the value of delta ranges from 0 to 1, whereas for Puts from -1 to 0.
Calls have a positive delta because Call premiums increases when the underlying stock price increases, and vice versa, assuming all other factors remain the same.
In contrast, Puts have a negative delta because the Put option price drops when the stock price goes up, and vice versa.

GAMMA and the position in the market:
* Both long calls and long puts always have positive gamma.
* Both short calls and short puts always have negative gamma.
* Stock has zero gamma because its delta is always 1.00 � it never changes.

Positive Gamma means the delta will increase when the underlying stock price increases, and will decrease when the stock price decrease (positive relationship).
Negative Gamma means the delta will decrease when the underlying stock price rises, and will increase when the stock price drops (negative relationship).

What does �long calls and long puts have positive gamma� mean?
What does �short calls and short puts have negative gamma� mean?
Please refer to the following post for further discussion about this:
Option Greek: GAMMA

THETA and the position in the market:
* Long calls and long puts always have negative theta.
* Short calls and short puts always have positive theta.
* Stock has zero theta � its value is not eroded by time.

Positive theta means that the option value will increase as the time passes, while negative theta means the option value will fall as the time passes.
Therefore, it makes sense that long options have negative theta and short options have positive theta.
If options are continuously losing their time value as days pass, a long option position will lose money because of theta, whereas a short option position will make money because of theta.

VEGA and the position in the market:
* Long calls and long puts both always have positive vega.
* Short calls and short puts both always have negative vega.
* Stock has zero vega � it�s value is not affected by volatility.

Positive vega means the option price increases when volatility increases, and decreases when volatility decreases.
Negative vega means the option price decreases when volatility increases, and increases when volatility decreases.

RHO and the position in the market:
Long calls and short puts have positive rho.
Short calls and long puts have negative rho.

Positive rho means the option price increases when the interest rate increases, and decreases when the interest rate decreases.
Negative rho means the option price decreases when the interest rate increases, and increases when the interest rate decreases.

For more detailed discussion, go to: Option Greeks.

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Options Greeks vs. OTM, ATM & ITM Options: Summary

1) Option Greeks: DELTA
Delta is a measure of the change in the option price resulting from a change in the underlying stock price.

The delta values will be positive for Calls & negative for Puts.

At-the-money (ATM) options have (absolute) deltas around 0.5.
Out-of-the-money (OTM) options have (absolute) deltas between 0 to 0.5.
In-the-money (OTM) options have (absolute) deltas between 0.5 to 1.




2) Option Greeks: GAMMA
Gamma is a measure the rate of change of delta due to a one-point change in the price of the underlying stock.

Unlike delta, gamma is always positive for both Calls and Puts.

Gamma is the highest for the ATM options, and gradually gets lower as it moves furthers towards ITM and OTM.
That means that the delta of ATM options changes the most when the stock price moves up or down, as compared to ITM & OTM options.

3) Option Greeks: THETA
Theta is a measure of the rate of decline of option�s time-value resulting from the passage of time (TIME DECAY).

Theta is typically highest for ATM options, and is progressively lower as options are ITM and OTM.
This makes sense because ATM options have the highest time value component, so they have more time value to lose over time than an ITM or OTM option.

4) Option Greeks: VEGA
Vega is a measure the sensitivity of an option�s price to changes in Implied Volatility (IV).

Vega is highest for ATM options, and is gradually lower as options are ITM and OTM.This means that the when there is a change in volatility, the value of ATM options will change the most. This makes sense because ATM options have the highest time value component, and changes in Implied Volatility would only affect the time value portion of an option�s price.




For more detailed discussion, please refer to the following post:
Option Greeks

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What To Consider When You Are Buying An Overpriced (High IV) Options

In the previous post, we discussed that when IV is relatively low (option is cheap) and is expected to rise, we should buy options (i.e. consider options strategies that allow us to be an option buyer).
On the other hand, when IV is relatively high (option is expensive) and is expected to drop, we should sell options (i.e. consider options strategies that allow us to be an option seller).

However, often we�d like buy options despite the relatively high IV (i.e. options is considered expensive).
For example, for myself, I like playing directional swing trading to take advantage the expected price movement for 1 � 3 days. Hence, in this case, I�ll just buy straight call or put options depending on the expected direction. However, frequently the option is relatively high in IV (�expensive�). Is it all right if I buy the options?
To me, buying options when IV is high is still all right.
However, there are a few things to consider when buying options with high IV:

1) As mentioned earlier, usually IV is high because we're expecting certain events that can cause the drastic price movement (e.g. earnings announcement, FDA approval, M&A, etc.). Before that event happens, the IV normally will not drop drastically, and is also quite likely to rise even higher and peak on the day of the event itself.
So, if I'd like to play swing trading or day trading, I have to make sure that I close my position (sell the options) before the event take places.

2) Assess the Reward / Risk ratio of a potential trade by having different scenarios of IVs, expected / target stock prices & time remaining to expiration (using Options Calculator / Pricer).
By inputting different IV numbers (e.g. the highs, lows, or average, etc.) as a parameter in the Options Calculator / Pricer, you can see how IV can potentially affect your trade under different scenarios.
This could also help you to assess whether it�s better to use ITM (In-The-Money), ATM (At-The-Money), or OTM (Out-of-The-Money) options.
As discussed previously on more understanding about IV, ATM and OTM options are more affected by IV movement than ITM options.

(You can refer to the link for more discussion on how to get IV data)

3) Some traders like to bet with options over the events that can cause the drastic price movement (e.g. earnings announcement, FDA approval, M&A, etc.).
In this case, we have to bear in mind that some degree of price movement has been priced in with the high IV. So, when IV drops considerably right after the announcement, we can only gain if the price movement is big enough to offset the drop in IV. Otherwise, we'll lose money with options even though the stock price moves to the expected direction.
(As discussed more detail in this post).

4) When IV is relatively expensive and you don�t want your options to be affected too much by the IV changes, you may want to consider buying further ITM (In-The-Money) options.
Remember that IV has a considerable effect on the option price, but it affects only the time value component of an option's price, not on the Intrinsic Value
(Please refer to this post: More Understanding About Implied Volatility).
Therefore, the deeper ITM options will be less affected by the changes in IV, as it has less time value component in the option price. The further ITM an option, the lesser time value component it has.

To understand more about Implied Volatility, go to: Understanding Implied Volatility (IV).

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* Learning Charts Patterns

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Example On How Implied Volatility (IV) Affects Option�s Price Significantly

As discussed earlier, in options trading, Implied Volatility (IV) has a considerable impact on an option�s price. An option�s price can go up or down due to changes in IV, although there is no change in the stock price. Some times, for instance, we also find a stock price has increased, yet the Call option of the stock did not increased, but it dropped instead.
Now, let�s see a simple example on how IV affects an option�s price considerably.

In the prior post, it�s shown that IV will normally begin to rise starting from a few weeks before the announcement day. And once the announcement is out, the IV will drop significantly.

The fact that the IV will drop considerably right after the announcement is extremely important to note, particularly when you�re trading options by buying straight call / put options (directional play) or buying strangle / straddle (non-directional play) over earnings announcement.
This is typically the reason why you might see that the stock price has gapped up / down in your direction, but yet the option�s prices do not move profitably.
Why is it so?
Remember that, for both Call & Put options, an increase in IV will increase an option�s price, whereas a decrease in IV would decrease an option�s price.
(You may want to refer to the posts on Vega or Options Pricing for further discussion).

The increase in IV before the earnings announcement is to �anticipate� the volatility as a result of the announcement. In other words, certain magnitude of the price movement (either up or down) has been �priced in� by the increase in IV, which causes the option�s price to be more �expensive� than normal.
Once the announcement is out, the IV will drop significantly, which would affect the option�s price negatively.

Therefore, to be profitable in such cases, the increase / decrease in stock price must be big enough to offset the negative impact of the drop in IV on option�s prices.
And for strangle / straddle, the stock price movement must be even much bigger in order to offset both the drop on option�s prices at both legs (call & put legs) due to the drop in IV as well as the drop on option�s price at the other leg after the stock price moves to certain direction.

Therefore, in this case, it�s important to first assess the Reward / Risk ratio of a potential trade by inputting different scenarios of IVs and expected / target stock prices (using Options Calculator / Pricer).
By doing this, you can anticipate what your best & worst scenarios are, have your risk & return calculated, and determine if the trade is worth taking.

To understand more about Implied Volatility, go to: Understanding Implied Volatility (IV).

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The Behavior of Implied Volatility (IV) & Historical Volatility (HV) Before & After Earnings Announcement

As mentioned before, Implied Volatility (IV) does factor in future important events / news which are expected to move the option�s price considerably within the next 30 trading days (e.g. earnings announcement, FDA approvals, etc.).

For some regular events, such as earnings announcement, which typically take place on a quarterly basis, we could see some common behavior before & after the announcement.
Generally, IV would normally start to increase since a few weeks before the announcement day.
Once the announcement is out, the IV will usually drop significantly.
On the other hand, the Historical Volatility (HV) may rise drastically should there were a significant gap up / down in stock price after the announcement.

Example:





Note:
RIMM�s Earnings Announcement: 28 Sep 06, 21 Dec 06, 11 Apr 07, 28 Jun 07, 4 Oct 07.

As we can see from the chart, the IV (Implied Volatility) was normally increasing when the announcement approached, and it dropped significantly right after the announcement.

On the contrary, when there was a significant price gap (up / down) after the announcement, the HV (Historical Volatility) increased drastically, reflecting the sudden actual price movement (e.g. Price gapped up after earnings announcement on 28 Jun 07).
Also notice that about 30 trading days after that, HV fell drastically. This is because the price data on the day just before the price gap occurred has been excluded from the HV calculation. (Remember that HV is a measure of the fluctuations of the stock price over the past 30 trading days).

Next, what�s the impact of the above behavior when we�re trading options over the announcement? We�ll discuss it further later. Please stay tune. :)

To understand more about other aspects of Implied Volatility, go to: Understanding Implied Volatility (IV).

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How To Determine If An Option Is Cheap (Underpriced) Or Expensive (Overpriced) � Part 2

Go back to Part 1.

How To Determine If IV is High or Low? (Cont�d)

Example:



Picture courtesy of: ivolatility.com

For AAPL, the IV figures (gold colored line) range between 24% to 54%.
The peaks / highs of the IV charts are around 45% - 55%. When the IV is relatively high for the stock, that means the option�s price is relatively expensive.
On the other hand, the bottoms / lows of the IV charts are about 25% - 30%. When the IV is relatively low for the stock, that means the option�s price is relatively cheap.
The area between 35% - 40% seems like the average area. Hence, when IV is around this area, the option�s price can be considered quite �reasonable�, not �expensive� or �cheap�.
Notice that when the IV is at the peak or at the bottom, it tends to move back towards its average area.

Implied Volatility (IV) & Options Strategy Consideration
When IV is relatively low (option is cheap) and is expected to rise, buy options (i.e. consider options strategies to take advantage of the expected move that allow us to be an option buyer).
For example:
You expect the price to go up in the near term. Currently, the IV is also relatively low and it�s expected to increase, as it is approaching earnings announcement in a few weeks ahead. When you buy Call options, the option�s price could increase not only due to the rising stock price, but also as a result of the rising IV. Even when the price stays flat, the option�s price might still increase due to the increase in IV.
Buying Straddle or Strangle also can benefit from the rising IV.

When IV is relatively high (option is expensive) and is expected to drop, sell options (i.e. consider options strategies to take advantage of the expected move that allow us to be an option seller).
For example:
When you�re bullish, you may want to consider a Bull Put Spread, which allow you to sell options (and collect premiums) with a limited risk.
On the other hand, when you�re bearish, you can consider a Bear Call Spread.

To understand more about other aspects of Implied Volatility, go to: Understanding Implied Volatility (IV).

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* Learning Candlestick Charts
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How To Determine If An Option Is Cheap (Underpriced) Or Expensive (Overpriced) � Part 1

As discussed before in the previous post, in options trading, Implied Volatility (IV) has a huge impact on an option�s price.
An option�s price can move up or down due to changes in IV, even though there is no change in the stock price.
Some times, for instance, we also find a stock price has gone up, however the Call option of the stock did not increase, but it decreased instead. This kind of case is not surprising if we understand the factors that affect an option�s price. The reason why this phenomenon happens is usually due to a drop in IV.

Therefore, before we buy or sell an option, it is important to check if an option is relatively cheap (underpriced) or expensive (overpriced).
An option is deemed cheap or expensive not based on the absolute dollar value of the option, but instead based on its IV.
When the IV is relatively high, that means the option is expensive.
On the other hand, when the IV is relatively low, the option is considered cheap.

How To Determine If IV is High or Low?
Often, we come across some articles which suggested the way to evaluate if an option is cheap (underpriced) or expensive (overpriced) is by comparing IV against HV at a particular point of time.
When IV is considerably higher than HV, it means an option is expensive. On the contrary, when IV is much lower than HV, an option is considered cheap.

However, the problem is that IV is hardly related to HV, because IV is a prediction of stock�s future fluctuation for the next 30 trading days, while HV is a measure of stock�s fluctuation over the past 30 trading days. IV usually takes into account news or the coming important events. When an important event is expected to happen in the next 30 days (e.g. earnings announcement, FDA approvals, etc.), Implied Volatility will be relatively high. However, this may not be reflected in the �what has happened� during the past 30 days. Therefore, actually we can�t really compare IV vs. HV figures at a particular point of time.

To determine if an option is cheap (underpriced) or expensive (overpriced), IV figure at a particular point of time should be compared against its past IV trend.
Typically, IV (and HV as well) will oscillate from a period of relatively low volatility to a period of relatively high volatility. When IV is relatively high or low, normally it will tend to move back towards its average value. This pattern can be used to assess the reasonableness of an option�s price.

We�ll discuss an example and how to advantage of IV movement in Part 2.

To understand more about Implied Volatility, go to: Understanding Implied Volatility (IV).

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More Understanding about Options Time Value

As we know, an option�s price comprises of 2 components: Intrinsic Value + Time Value.
Assuming all other things remain constant (i.e. no changes in the underlying stock price and volatility), the time-value component of an option is affected by 2 variables (both for Call & Put Options):

* Time remaining until expiration.
The longer the time to expiration, the more time value the option will have.

* The closeness of the option Strike Price to the money.
At-The-Money (ATM) options have the maximum level of time value, and the time value decreases as it moves to deeper In-The-Money Options (ITM) and deeper Out-Of-The-Money (OTM) options (like inverted-U curve).
Time value is at its highest level when an option is ATM because the potential for Intrinsic Value to begin to increase is the greatest at this point.

Note:
ATM options have the highest level of time value. Time value decreases as it moves to deeper ITM or OTM options (like inverted-U curve).
This can be understood better if we see the time value as the price that people are willing to pay for the chance / uncertainty as to whether or not an option will finish ITM.
The more uncertain, the higher the time value will be.
An option that is far OTM has almost no chance of finishing ITM. As such, it will not command a high time value.
An option that is already deep ITM is almost certain that it will finish ITM, hence time value is smaller.
But ATM or near ATM options have more uncertainty as to whether or not the options will finish ITM, and therefore these options have a higher time value.



In addition, we know that for both Calls & Puts, the time value component of an option price decreases as expiration is nearing, and the decrease rate is accelerating as it is getting closer to expiration, particularly for At-The-Money (ATM) options. This means that the amount of time value disappearing from the option price per day gets bigger with each passing day.

Please note here that Time Value decrease at an accelerating rate as expiration nears is true only for ATM option. This is because for ATM option, Theta increases as an option get closer to expiration (Please refer back to the previous post here).
For ATM option, time value decreases sharply particularly the last 30 days before expiration.

Nevertheless, for both ITM & OTM options, Theta decreases as an option is approaching expiration. Hence, for both ITM & OTM options, Time Value actually decreases at a decelerating rate as expiration nears.

Sigma Options had a good article about this in �What You Didn�t Know About Time Decay�.

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* In-The-Money, At-The-Money, and Out-Of-The-Money Options
* Option Price Components
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OPTION PRICING: How Is Option Priced? (Part 2)

In Part 1, we know that there are 6 factors that affect option's price: option�s strike price, stock price, time to expiration, implied volatility, interest rate, and dividend.

Nevertheless, the impact of interest rate and dividend are often considered negligible as compared to the other factors. Most of the time, for each level of strike price, an option�s price will move due to the movement of underlying stock price, volatility and time.

The Black-Scholes formula can be used to calculate the theoretical value of an option based on the above factors.

What is the use of knowing an option�s theoretical value? By knowing the option�s theoretical value, option traders can compare the prevailing option price in the exchange against this theoretical value to determine if a particular option contract is over or under valued, hence helping them in their option trading decision.

Options Calculator / Pricer is normally used to help compute the theoretical value of option price.

THE IMPACTS ON OPTION�S POSITION

Since option�s buyers (long position) will profit when the option price rises after they buy (Buy Low, Sell High), whereas the seller (short position) will profit when the option price falls after they sell (Sell High, Buy Low), the impact of the above factors will also be different.

The following table shows how the major factors (stock price, time to expiration, implied volatility) affect an option�s position.

Example:

Increase in Implied Volatility (IV) would increase option�s price (both calls & puts), assuming other factors unchanged. Hence, this will be favorable for option buyers who will gain if the option price increases (buy low, sell high), but unfavorable for option sellers that will profit if the option price drops (sell high, buy low).

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* Options Trading Basic � Part 1
* Options Trading Basic � Part 2
* Understanding Implied Volatility (IV)
* Option Greeks
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OPTION PRICING: How Is Option Priced? (Part 1)

Option price does not always move in conjunction with the price of the underlying stock. As such, it is important to understand what factors contribute to the movement in the option price, and what effect they have.
There are 6 factors that affect option price:

1. OPTION STRIKE PRICE
Strike price determines whether an option is In-The-Money, At-The-Money, and Out-Of-The-Money.
The more deeply In-The-Money (ITM), the higher the option price will be, as it carries more intrinsic value.
The further an options is Out-Of-The-Money (OTM), the lower the option price will be.

2. CURRENT STOCK PRICE
This factor has opposite impact on call and put (assuming all other factors kept constant):
When stock price increase, Call premium will increase and Put premium would decrease.
When stock price decrease, Call premium will decrease and Put premium would increase.

3. TIME (NUMBER OF DAYS) REMAINING UNTIL EXPIRATION
This factor affects the Time Value component of an option price. All other things being equal, an option with more days to expiration will have more Time Value component than an option with fewer days to expiration.
In general, for both Calls & Puts, the Time Value component of an option price decreases or �erodes� as expiration is nearing (often called �Time Decay�). And the Time Value component would decrease at an accelerating rate as it is getting closer to expiration, particularly for At-The-Money (ATM) option.
Due to time decay effect, even though a stock price, say, just remains constant till expiration, an Out-Of-The-Money (OTM) option price which contains only time value will decrease over time and then expire worthless. Therefore, time is the enemy of options buyers, but a friend for options sellers.

4. IMPLIED VOLATILITY (IV)
Volatility is a measure of risk / uncertainty of the underlying stock price of an option. It reflects the tendency of the underlying stock price of an option to fluctuate either up or down. Volatility can only suggest the magnitude to the fluctuation, not the direction of the movement of the price.
Implied Volatility (IV) here is an estimate of future volatility. Since it is only an estimate, it is the most subjective and probably the most difficult factor to quantify. Nevertheless, IV can have a significant impact on the time value component of an option's premium.
Higher Implied Volatility reflects a greater expected fluctuation (in either direction) of the underlying stock price, and as such it is more likely that the underlying stock will move in your favor.
As a result, the higher the Implied Volatility of the underlying stock, the more expensive its options (both Calls & Puts) will be, because there is a greater possibility that the options will end up in your favor profitably.

5. INTEREST RATE
The impact of interest rate on option�s price has something to do with the �carrying cost� of stocks. When you are bullish on a certain stock, it is much cheaper to buy Call option than the stock itself. The interest cost should you buy the stocks is built into the Call option�s value.
In this case, all other things kept constant, an increase in interest rates will lead to an increase in Call premiums and a decrease in Put premiums.
However, in reality, all other things rarely remain constant. An increase in interest rates will generally result in a drop in stock prices, and this impact would often overwhelm the effect of interest rate on option price. Therefore, the impact of interest rate on option�s price is not certain, depending on the combined effects of the change in stock price (due to interest rate changes) and the �carrying cost� effect.

6. DIVIDEND
A stock price is expected to drop by the amount of the dividend on the ex-dividend date. Hence, high cash dividends imply lower call premiums and higher put premiums.

Continue to Part 2

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Option Chain

Option Chain is a list of option prices of a particular underlying stock for various strike prices, expiration dates, and option types (calls or puts). This is where option traders get the current market price of an option during trading hours. The prices in the Option Chain will change throughout the trading day based on the stock price movement, volatility and time.

A sample of option chain can be seen below.

Picture courtesy of Optionsxpress.

THE COMPONENTS OF OPTION CHAIN:

• Option Expiration Month: The months on top of the table.


• Strike Price: The prices at the center (vertical).


• Calls are at the left of the Strike Price, and Puts are at the right of the Strike Price.


• Ask Price: The price when you buy an option (i.e. the price where the market makers are willing to sell).


• Bid Price: The price when you sell an option (i.e. the price where the market makers are willing to buy).


• Last Price: The last traded price.


• Volume: The number of contracts traded for that particular option during the trading day.


• Open Interest: The total number of option contracts that are still open for that particular option.


• Symbol: A unique symbol assigned to that particular option of a certain underlying stock with certain strike price & expiration month.

A FEW THINGS TO HIGHLIGHT:

• You can determine whether a certain option is In-The-Money (ITM) or Out-Of-The-Money (OTM) by comparing it with the current market price. In this example, the current market price is available just below the word �Strike Price�.


• Some Option Chain may differentiate between ITM or OTM options by using different color. In this example, ITM options are shaded in yellow, while OTM options are in white.


• For Call options, ITM options (shaded in yellow) are at the upper left side of the table. As you can see, the lower the Strike Price (the more ITM the call options), the more expensive the call option price will be. On the other hand, OTM options (in white) are at the lower left side of the table. The higher the Strike Price (the more OTM the call options), the cheaper the call option price will be.


• For Put options, ITM options (shaded in yellow) are at the lower right side of the table. As you can see, the higher the Strike Price (the further ITM the put options), the more expensive the put option price will be. On the other hand, OTM options (in white) are at the upper right side of the table. The lower the Strike Price (the further OTM the put options), the cheaper the put option price will be.

EXAMPLES:

The picture above is the Option Chain for DELL with Expiration Month of Jun 07.
In this example, the last price of DELL is $26.02. This price is in between Strike Price 25 and 27.5.

Therefore, for Calls (at the left of the Strike Price column), the Strike Prices from 25 or lower are ITM options, while the Strike Prices from 27.5 or higher are OTM options.

And for Puts (at the right of the Strike Price column), the Strike Prices from 25 or lower are OTM options, while the Strike Prices from 27.5 or higher are ITM options.

Suppose you want to buy 2 contracts of DELL Jun 25 Call, the option price will be $1.7 (Ask Price), hence you need to pay: $340 (= $1.7 x 2 contract x 100 shares/contract).

Suppose you want to sell 2 contracts of DELL Jun 25 Call, the option price will be $1.6 (Bid Price), as such you will receive: $320 (= $1.6 x 2 contract x 100 shares/contract).

As you can see, if you buy an option and sell it immediately, you will lose $0.1 (=1.7 � 1.6) due to the Bid-Ask Price Spread.

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Option Price Components (Part 2)

Go back to �Part 1�

EXAMPLES FOR INTRINSIC VALUE & TIME VALUE CALCULATION:

For Call Option:
Current stock price = $30.
The price of Call option with Strike Price of $20 = $12
This call option is In-The-Money (ITM) option because Strike Price ($20) < Stock Price ($30).
Intrinsic Value = Stock Price � Strike Price = $30 � $20 = $10.
Time value = Option price � Intrinsic Value (if any) = $12 - $10 = $2
Here, the call option is said to be In-The-Money with intrinsic value of $10, as it allows the call option buyer to immediately buy a $30 stock at $20 the moment he bought it.

Current stock price = $30.
The price of Call option with Strike Price of $40 = $0.5
This call option is Out-Of-The-Money (OTM) option because Strike Price ($40) > Stock Price ($30).
Intrinsic Value = 0 (No intrinsic value for OTM option)
Time value = Option price � Intrinsic Value (if any) = $0.5
Here, the call option is called Out-Of-The-Money, as it is better for the call option buyer to buy the stock from the market at $30 than to immediately exercise the option at $40 strike price.


For Put Option:
Current stock price = $30.
The price of Put option with Strike Price of $35 = $6.
This put option is In-The-Money (ITM) option because Strike Price ($35) > Stock Price ($30).
Intrinsic Value = Strike Price � Stock Price = $35 � $30 = $5.
Time value = Option price � Intrinsic Value = $6 - $5 = $1.
Here, the put option is said to be In-The-Money with intrinsic value of $5, as it allows the put option buyer to immediately sell a $30 stock at $35 the moment he bought it.

Current stock price = $30.
The price of Put option with Strike Price of $25 = $0.3.
This put option is Out-Of-The-Money (OTM) option because Strike Price ($25) < Stock Price ($30).
Intrinsic Value = 0 (No intrinsic value for OTM option).
Time value = Option price � Intrinsic Value (if any) = $0.3.
Here, the put option is called Out-Of-The-Money, as it is better for the put option buyer to sell the stock in the market at $30 than to immediately exercise the option at $25 strike price.

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