I have spoken with many new options traders and realized they do not have a full understanding of how options pricing works. Most traders in India trade the equivalent of a lottery ticket. They buy deep out of the money options in the hopes that a large move will make them rich. However, the likelihood of that happening is extremely low and most of those traders end up losing money.
Without a full understanding of the risk measures, you could be doing more harm than good. In order to be a complete options trader, you should have a comprehensive understanding of both the directional movement of the underlying asset as well as the volatility risk involved in the options themselves. Changes in volatility will have a greater impact on options pricing than movement in the underlying security’s price. To understand risk, you need to learn how to speak Greek! I’m not suggesting a vacation to Santorini, although that’s not a bad idea, but rather learning the risk measurements in options we call the Greeks.
The risk measurements for options are named after several Greek letters. The two I am going to discuss today are Delta and Vega. Delta tells us several things, one of which is how much the price of the option will change given a change in the underlying stock’s price. Vega refers to the change in price given a change of the volatility in the price of the stock. Looking below, we see the Greeks on the December 820 Call and the 900 Call for the stock Reliance.
The Delta for the 820 Call is .77 which means that the option’s price will change by Rs. 0.77 for every one Rupee change in the price of Reliance. However, when the volatility of Reliance changes by 1%, the option’s price will only change by Rs. 0.34. It appears at first glance that the change of stock price would have a greater impact on the option price since our delta is larger than vega. Ah, but that’s where you’d be wrong. At the time I am writing this article, there are seven days left until the expiration of the December options. The price of Reliance is in a sideways channel and has only moved Rs 7.00 in the previous seven days. But the standard deviation of the volatility for that option is 10%! This could easily wipe out or at least reduce profits in the trade.
A trader who tries to buy the cheaper, out of the money option is in for a bigger challenge. The Delta is only 0.04 while the Vega is 0.09. You need a fast move on the price of the stock to outpace the losses from volatility changing.
High volatility = high priced options. But if a trader guesses wrong on volatility, even if they are right on the direction of price, they run the risk of diminished returns or even loss! It is important to be fully educated when dealing with the markets. Even more so for options trading as they are sophisticated instruments. Learn how to trade options by attending one of Online Trading Academy’s Options courses at a center near you. You could trade without the education, but at what cost?