I am doing an internship as a junior equity research analyst, and my job is to cover options on CNX media and to advise my clients about the risk inherited in options. Now to calculate and identify the risk in options, I need to calculate delta, Vega, Theta, Rho, and Lambda. These Greeks will give me the risk information which can be passed further to clients or can be helpful in recommendation. In FRM-I you will be learning the use and importance of Greeks.
Greeks in brief:-
Naked And Covered Position
We now know how calls and puts can be effectively used to make profits. Let’s take a look at some of the option strategies used by traders and their subsequent consequences.
- The covered call is one amongst the most popular option trading strategies. Here, no doubt the rewards are limited, but simultaneously the risks of downside losses are also minimized. The name ‘covered’ has been derived from the fact that the option contract is already covered by the stock owned by the option writer.
- Unlike covered call, one strategy open to the hedger is to do nothing i.e. to sell the calls on a stock without ensuring the availability of the underlying stock with you. This is referred to as a naked position.
Stop Loss strategy
The above two strategies can be combined to construct a stop loss strategy. This ‘stop - loss’ as the name depicts is a technique of limiting the quantum of losses in a trading session. However, this concept of a stop loss strategy is more theoretical and has no significance in a practical scenario. If this was possible, everyone would be able to earn from a riskless arbitrage. Therefore, neither a naked position nor a covered position provides with a satisfactory hedge.
Hence, it is of utmost importance to learn advanced sophisticated hedging techniques with options. But before that, you should be well versed with the Greeks influencing the option’s prices.
Until now we had discussed option mechanics and pricing. We are now fully aware that careful and well thought use of the option strategies has a potential for huge profits. There is a simultaneous downside of options too. This is particularly true for those investors who trade options without prior understanding of the risk factors affecting their prices.
Why do we need to know about Greeks?
The above situation is analogous to flying an aeroplane without an inherent ability to read instruments. If all of a sudden the weather goes bad, an inexperienced pilot will get panicky, totally unaware of the beneficial use of the panel of instruments at his disposal.
This class on Greeks will make you comprehend the risks and potential rewards originating from trading in options/option strategies. By applying the knowledge of Greeks, you can aptly take appropriate and necessary actions to avoid/minimize losses and enhancing gains.
The Greeks, having been named so because of their representation by Greek letters describe option risk sensitivities. They denote the sensitivity of various option types derived from asset classes like commodities, currencies, bonds, equities etc.
Following are the five factors influencing the prices of options:
- Changes in price of the underlying (DELTA)
- Changes in the Risk free rate - Rf (RHO)
- Changes in Volatility (VEGA)
- Time Value Decay (THETA)
- Change in Delta (GAMMA)
This session on Greeks will summarize the key variables affecting option prices, and their roles in determination of risks and rewards in options trading.