Volatility

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International Securities Exchange

Alex JacobsonVice President, Educationwww.iseopt
ions.com
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Understanding The Option Greeks And Their
Importance In Setting Expectations

• ISE EDUCATION WEBINAR
• October 2006

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For the sake of simplicity, the examples that
follow do not take into consideration commissions
and other transaction fees, tax considerations,
or margin requirements, which are factors that
may significantly affect the economic
consequences of a given strategy. An investor
should review transaction costs, margin
requirements and tax considerations with a broker
and tax advisor before entering into any options
strategy. Options involve risk and are not
suitable for everyone. Prior to buying or
selling an option, a person must receive a copy
of CHARACTERISTICS AND RISKS OF STANDARDIZED
OPTIONS. Copies have been provided for you today
and may be obtained from your broker, one of the
exchanges or The Options Clearing Corporation. A
prospectus, which discusses the role of The
Options Clearing Corporation, is also available,
without charge, upon request at 1-888-OPTIONS or
www.888options.com. Any strategies discussed,
including examples using actual securities price
data, are strictly for illustrative and
educational purposes and are not to be construed
as an endorsement, recommendation or solicitation
to buy or sell securities.
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www.iseoptions.com

• Free volatility data on all ISE listed options
• Updates on ISE broad market index products
• Updates on ISE sector options
• education_at_iseoptions.com

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Fact

• All options strategies work
• They each describe a specific set of expected
  outcomes -- Price action --Volatility -- Time
• No strategy works all the time

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Option Pricing

• To calculate an options value, you need
• The Price of the underlying
• The Strike Price of the option
• The Time until the option expires
• The Cost of Money (Interest Rates less dividends,
  if any)
• The Volatility
• Theoretical Value of the Option

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Option Nationalities

• European Options Index Options Trade
  all day Exercise only at expiration Friday
• American Options Stock options ETF
  options Trade all day Can be early
  exercised

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Option Pricing Models

• Black Scholes Best for European
  options pricing
• Binomial (Cox Ross) Best for
  American options pricing

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Option Pricing Models

• Many variations of these models exist
• Their outputs can vary
• Usually caused by dividend valuations
• Worrying about these differences is a waste of
  time for the typical investor

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Option Pricing Models

• Listed options trading begins in April 1973
• In 1973 a 5 function calculator cost 300
• In 1973 a years tuition at The University of
  Illinois cost about 800

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Price Movements

• Theoretical Values Change because Options Exist
  in a dynamic environment
• Stock Prices Change
• Time Goes By
• Interest Rates are Adjusted
• Volatility Increases and Decreases

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Option Pricing Models

• Pricing models also output a series of
  GREEKS The importance of the GREEKS
  Setting expectations Selecting
  strike prices Selecting expirations Managin
  g position risk

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Option Evaluation

• UNDERSTANDING
• DELTA
• GAMMA
• THETA
• RHO VEGA

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DELTA

• RATE OF CHANGE IN THE OPTION PRICE FOR A CHANGE
  IN THE UNDERLYING SECURITY
• Calls have positive DELTA
• Puts have negative Delta

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DELTA

• ATM Call will have about .50 Delta or be referred
  to as 50 Deltas
• OTM Call will have a lower Delta something like
  .15 or .20
• ITM Call will have a higher Delta something like
  .70 or .80

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Delta

• Call options have positive Delta positive
  correlation to stock price change
• Put options have negative Delta negative
  correlation to price change

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Delta

• A Put/Call pair will have a total Delta with an
  absolute value of 1.00
• Stock price 52.00 50 Call Delta of
  .57 50 Put Delta of -.43

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DELTA

• Is not constant
• As options move more in the money delta increases
• As options move more out of the money delta
  declines

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DELTA

• Changes as time passes
• May change with changes in volatility

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GAMMA

• THE RATE AT WHICH DELTA CHANGES FOR A CHANGE IN
  THE PRICE OF THE UNDERLYING SECURITY
• GAMMA IS WHAT OPTIONS BUYERS ARE PAYING FOR

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GAMMA

• An ATM option is about 50 delta 10 gamma
• 50 shares of stock is 50 delta
• The ATM option auto-adjusts as the stock price
  changes, time passes or volatility changes
  delta goes to 60 for a 1 move
• 50 shares of stock is 50 delta

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THETA

• THE CHANGE IN THE PRICE OF AN OPTION FOR A CHANGE
  IN THE TIME TO EXPIRATION
• The daily rent buyers pay
• The daily rent sellers receive

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RHO

• CHANGE IN THE VALUE OF AN OPTION FOR A CHANGE IN
  THE INTEREST RATE/DIVIDEND CALCULATION
• Not a big deal for most users as the impact is
  small
• Becomes a big deal in the calculation of LEAP
  option positions

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RHO

• Changes in interest rates have a very small
  impact on short dated option values
• Changes in interest rates may have a large impact
  on stock values
• Generally the impact on stock values is more
  important to the option pricing than the interest
  rate change

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RHO

• Reality check ATM 50 Call Fed
  raises rates 1 Call price changes by
  .02 RHO just isnt a big deal

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VEGA (kappa or omega)

• CHANGE IN THE VALUE OF AN OPTION FOR A CHANGE IN
  THE VOLATILITY ASSUMPTION
• Different for different strikes and expirations
• Biggest impact on short term OTM options

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VEGA

• A well informed option user needs to have a good
  working understanding of this GREEK
• Earlier Volatility webinar archived in our
  education section at www.iseoptions.com
• Best to think about VEGA in percentage impact

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Benefits Of Trading At ISE

• Largest equity options market
• First and proven all-electronic platform in the
  US
• Spreads traded as spreads
• Electronic buy/write capability

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www.iseoptions.com

• Free volatility data on all ISE-listed options
• Updates on ISE broad market index products
• Updates on ISE sector index options

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International Securities Exchange