An option price is determined using five variables — spot price, strike price, time to expiry, the risk-free rate, and volatility of the underlying asset’s returns. The option Greeks provide an approximation as to how an option price is likely to increase or decrease when any of these five variables change during the life of an option. This week, we provide a cheat sheet to use option Greeks in your trading decisions.
ATM matters
The rule is simple. You must choose a strike that has the maximum gamma and vega when you initiate a long position. Why?
Options have asymmetric payoffs. That is, the upside potential from an option is much more than its downside risk. This characteristic comes from the fact that the delta of the option moves up more than it comes down for the same magnitude change in the underlying price. The change in the delta can be attributed to the option’s gamma. That is, when the underlying moves up, the delta increases by the amount of gamma. But when the underlying declines, the delta decreases by the amount of gamma (the new delta is the old delta plus the gamma when an underlying moves up but the old delta minus the gamma when the underlying declines).
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The at-the-money (ATM) strike has the maximum gamma. But the trade-off is that the ATM also has the highest theta, the loss in time value component of an option price with each passing day. Therefore, a slow movement in the underlying price will harm the option because of large time decay.
This brings us to vega or change in volatility. An option becomes more valuable when the underlying’s returns volatility increases. Note that volatility indicates both upward and downward price movement of the underlying asset. But upside volatility is likely to be more beneficial to a stock than downside volatility because asset prices cannot go below zero, leading to the asymmetric payoff in option prices. As with gamma, the ATM strike has the maximum vega. Interestingly, an increase in volatility is harmful for an in-the-money (ITM) option. This is because the probability of an ITM option becoming ATM increases with increase in volatility!
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To recap, an ATM strike has the highest gamma and vega, but also carries the highest time decay. So, you should buy an ATM option if you expect an underlying to move up and you expect volatility to change rapidly.
Optional reading
You should consider the Greeks when you have a view that implied volatility is likely to explode or implode. Ignoring the Greeks when you do not have a view on volatility may not hurt your chances of generating gains. This is because you are likely to choose either near ATM or immediate out-of-the-money (OTM) strike to set up your long position. Note that for either of these strikes, you are betting on the gains from intrinsic value being greater than the loss in time value.
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