If you have been trading for some time, we’re certain that you would have at least heard the terms -open interest and option greeks. Some of you would have a faint idea about their concepts and applications too. Many of the beginners find it extremely fascinating and want to learn more about it. So, without delaying, jargons and sounding like a Stock Market Institute in Delhi NCR, let us dive into the basics and importance of open interest with option greeks in option trading.
Open Interest and its Significance:
Open interest dashboard is one tabular arrangement of data fields containing bid price, ask price, volume, and implied volatility for two types of derivative contracts– Calls and Puts or Future contracts. To put it plainly, Open interest shows total number of available active options contracts. If the open interest is high, it means that there are good number of buyers and sellers in the contract signifying many active positions. A good open interest also confirms liquidity.
In layman terms it indicates the amount of money flowing into futures or options contracts. Increasing open interest represents more money coming into the market, which makes it easier to trade an option at a reasonable spread (difference) between the bid and ask. On the other hand, decreasing open interest denotes money flowing out of the market. Most of the option traders ignore this term of active contracts, which often leads to unplanned bearish circumstances.
Note: Open interest is updated only after all the trades in that specific trade date are processed. Thus, it will be available only the next morning.
Importance of Open Interest to Options Traders:
With open interest, you can get to know the liquidity of an option contract. An effective way of using open interest is to combine it with the volume of contracts traded. When the volume of contracts traded on a given day is greater than the existing open interest, it implies that trading for the day in that option was exceptionally high.
Open Interest and Trend Strength:
Open interest also indicates the strength of a trend. By now you know that increasing open interest represents more money and interest entering the market. This depicts and confirms that the existing market trend is gaining or showing strength and is likely to continue.
For e.g., Let us assume that the stock is increasing or is on an uptrend, then if supplemented with increasing open interest, there is more likelihood of continuation of the same. In the same way, during a down trend, if the augmenting open interest is increasing, then it means that the downtrend is strong.
Introduction to Greeks in Option Trading:
Whenever the price of the stock rises, buying price of a call option or its premium will rise and while the premium of put option will fall. Similarly, when the stock price goes down, the put option premium will rise and those of call options will fall. Greeks, being an important concept in options trading, tells you how the changes in certain factors impact the premium of options. Yet many Stock Market Courses in Delhi NCR neglect this concept because it is old. Option Greeks oversee some domains which include, price, time, and implied volatility.
1- Delta:
Like Zeus is considered the most powerful god as per the Greek mythology, and deemed “King of the Gods”, Delta is the ruler of all the options greeks. This is because of its large impact on the value of option’s premium.
Delta’s domain is price. It determines how much the option’s premium is susceptible to change if the underlying stock increases.
Example:
Delta gives us the value with which an option’s premium will rise if the price of an underlying security rises.
Let us consider, Delta value of +0.5 for 1,000 Calls and underlying stock’s price = Rs 1000.
Now after an increased stock price, new underlying price for the same stock = Rs 1010.
This means that the stock price is up by Rs 10, and hence the call premium will go up by 10*0.5 which is Rs 5
2- Gamma:
When it comes to Gamma, it is like the son of Delta and acts like a right hand to Delta in terms of price domain. With Gamma, one can measure the expected rate of change in Options Delta over time. To put is plainly, it is delta of delta. It is a second order risk factor and has higher value at ATM or when contract is closer to expiration and has least value for far OTMs.
3- Theta:
Theta’s domain is “time”. Theta estimates the value with which the options price can decay with each passing day, as the contract reaches close to its expiration date.
Example:
Let us say, the contract has a negative theta of 0.06, which means that the option premium is expected to decay by 0.06 every day.
Note: Time decay works in favor of sellers and not buyers.
4-Vega:
Vega is the god of implied volatility. Vega measures the amount of change in options premium for every 1% change in implied volatility of an underlying stock. Earning announcements, weather, political conditions, etc., are some of the reasons for the change in volatility. Depending on the strategy, a spike in volatility can prove to be a blessing or a curse.
Fast Fact:
• Options with prolonged expiration are bound to react more to a change in volatility.
• A drop in Vega will cause both calls and puts premiums to shrink.
• An increased Vega will increase the premiums of both calls and puts.
Rho:
Rho is like the younger son of Options Greeks. With Rho, one can figure out how options premiums react to interest rate changes. Since the interest rates move slowly, the impact of Rho on options trading is low. Due to this reason, Rho is often neglected when discussing Option Greeks in many Stock Market Courses in Delhi NCR.
Additional Points About Rho:
• With increased interest rates, the premiums of call options will typically increase.
• On the other hand, as the interest rates increase, the premiums of put options tends to decrease.
• Due to these reasons, Rho impacts call options in a positive way and put options in a negative way.
Options and Futures are not as simple as they might seem to be. Afterall Rev. Warren Buffet have deemed them weapons of mass destruction for some reason only. It is advised to have support of enough profitable experience and capital to start in derivatives. But with knowledge and mentorship from the Stock Market Institute in Delhi NCR, one can slowly master the derivatives
