Options Risks

The Basic

An option is the right to purchase or sell an underlying financial instrument on or before a specific date in the future.  The fact that an option is a derivative of an underlying instrument means that there are a number of components that make up the option that generate risk for both the option buyer and seller.  Although many options traders will look at the risks they have as option owners as the erosion of time value of their premium, there are other risks that should concern an investor which can assist in the process of optimizing their profitability.  

NB: The following article provides more information about the different types of risks associated with owning options.  You can read a more advanced article on how to hedge different types of risks here.

Options Greeks

Options are comprised of a number of sub-components that make up the bulk of the risks associated with owning or writing options.  Options generate outright directional risk, risk related to volatility, risks related to interest rates, and risk related to time decay.  Each of these risks can be hedged to mitigate an investor’s exposure.

The Delta

When an investor purchases a call option, they are purchasing the right to buy the underlying security.  As the security rises in price, the value of the option also generally rises.  There are a number of components within an option that creates this dynamic.  One of these components is the idea that the investors owns a theoretical number of shares of the underlying instrument which allows the value of the option to increase as the price of the underlying security increases.  This theoretical value is called the delta of the option.

When an investor purchases 1 share of a stock option they control 100 shares of the underlying security.  The theoretical number of shares will change with the underlying stock prices as well as time to maturity.  The time to maturity is the number of days prior to the expiration date.  When the underlying price of a security is above the strike price of a call option the option is considered in the money.  When the underlying price of a security is below the strike price of a call option it is considered out of the money.  When the underlying price of a security is equal to the strike price of a call option it is considered at the money.  Generally, at the money call options have a delta of 50%.  This means that one option contract on XYZ stock will have a theoretical value of 50 shares.  If the price of the underlying stock rises $1 dollar, with all other inputs into the option remaining the same, the value of the option will increase by $50 dollars (50 shares * $1).

Vega

The value of an option is determined by many factors, which include the perception of how much a specific security will move over a certain period of time.  Market participants value this by determining the implied volatility of a security.  The implied volatility is a forward looking concept, which is the amount a security will move in percentage terms over a specific period on an annualized basis.  Implied volatility is different from historical volatility as it’s the markets perception of how much a security will move in the future, compared to how much the market has actually moved in the past.  Historically implied volatility is the historical valuation of how much market participants priced in to an option.

The exposure and options trader has to implied-volatility is referred to as Vega.  A long Vega position means that a trader benefits as implied volatility rises.  A short Vega positions benefits when implied volatility of a security falls.  Generally owners of calls and puts are long Vega as their option values decline if implied volatility drops.

Gamma

Gamma is defined as the rate of change of the delta with respect to the underlying asset’s price. In a delta hedge strategy, gamma is sought to be reduced in order to maintain a hedge over a wider price range.

All individual option trades have inherent gamma risk associated with the position.  The close the strike price of an option is to the current underlying market, the higher the gamma.  The closer an option is to expiration the higher the theoretical gamma.

Gamma is dynamic risk, meaning the risk changes as other option inputs change.  Gamma is a function of the underlying price of the asset, along with time to maturity, interest rates, and implied volatility.  The underlying price plays the largest roll toward determining the gamma associated with an individual option.

Gamma is generally reflected as a percentage, which can be used to determine the change in your theoretical delta based on a specific market movement.  This process will allow a trader to simulate different movements in the market and delta hedge their position based on the gamma of an option.

For example, let’s assume a trader owns 1 contract of Apple options that expire in 30 days.  The strike of the option is “at the money” when Apple’s stock price is $600.  The gamma on the stock is .5%.  This means that for every increase of $2 increase in the stock price (from $600 to $602) the theoretical delta of the option position will increase by 1 share.  If a trader had a delta of .50 or 50 shares (1 contract equals 100 shares), a $2 increase in the price would generate a delta of 51 shares.

Positive gamma is associated with long positions in options.  When an investor purchases an option they pay a premium to the seller, and their inherent risk is time decay, gamma, vega, and delta.  The seller of the option has a negative gamma positive, and receives a premium to compensate for this type of risk.

Theta

The theta of an option refers to its exposure to time.  The value of an option erodes as the time to maturity declines.  An investor can measure the theoretical cost per day of an option which describes the daily theta.

When an option is out of the money, the entire option is described as only having time value.  This is also referred to as the extrinsic value of an option.    When the price of an underlying security moves above the strike price of a call option, the difference between the underlying security price and the strike price is called the intrinsic value and the balance of the value is referred to as the time value or extrinsic value.

Rho

Rho is the sensitivity of an option to changes in interest rates.  Rho generally is more influential on options that have long tenors.  This Greek calculation mainly focuses on the present value of the option those changes as the discount value of the security changes.

Rho can be hedged buy using interest rate products such as futures or swaps.  An investor who trades leap options, which are long dated options, could consider hedging their Rho exposure.

Adam

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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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