Topic 3 - Gamma, Vega, Rho
Understanding Option Greeks – Gamma, Vega, and Rho
Objective
To introduce beginning students to the concepts of Gamma, Vega, and Rho, while sprinkling in advanced applications for seasoned traders.
Introduction
- If Delta is the bread and butter of options trading, Gamma, Vega, and Rho are the gourmet garnishes that make it all come together. Let's explore how these Greeks can transform your trading!
- Gamma: The Delta of the Delta
- Vega: Sensitivity to Volatility
- Rho: Interest Rates and Long-Term Impact
Part 1: Gamma – The Delta of the Delta
Think of Gamma as the accelerator in a car. Delta tells you how fast you're moving, but Gamma tells you how much harder you’re pressing the gas pedal.
Basic Concept:
- Gamma represents the rate of change of Delta relative to the change in the price of the underlying asset.
- It tells you how much Delta will increase or decrease if the stock price moves by $1.
Advanced Nugget:
- High Gamma Risk: Around expiration, Gamma spikes for at-the-money options.
- Example: If the stock price hovers around the strike price close to expiration, Gamma can whip your Delta around rapidly, making hedging more critical and challenging.
Practical Use Case:
- Traders often manage Gamma risk by rolling positions or using spreads like butterflies or condors.
Part 2: Vega – Sensitivity to Volatility
If Gamma is the gas pedal, Vega is the road conditions. Smooth roads (low volatility) make for predictable driving, but rough roads (high volatility) can shake things up.
- Basic Concept:
- Vega measures an option's sensitivity to changes in implied volatility.
- Positive Vega = Long options (benefit from rising volatility).
- Negative Vega = Short options (benefit from falling volatility).
- At-the-money options have the highest Vega.
- Longer-dated options have higher Vega compared to shorter-dated ones.
This graph shows how Vega changes based on the stock price and the time left until expiration for options contracts. Let's break it down step by step so beginners can understand:
Key Points to Understand the Graph
What is Vega?
- Vega measures how much an option's price changes for every 1% change in implied volatility.
- Higher Vega means the option price is more sensitive to changes in volatility.
Stock Price vs. Vega
- The horizontal axis represents the stock price relative to the strike price of the option:
- At-the-Money (ATM): This is where the stock price is equal to the strike price of the option. It’s shown at the center of the graph.
- In-the-Money (ITM): Stock price is beyond the strike price for calls or below it for puts.
- Out-of-the-Money (OTM): Stock price is below the strike price for calls or above it for puts.
- Peak Vega:
- Vega is highest when the option is at-the-money.
- As the stock price moves further in-the-money or out-of-the-money, Vega decreases.
Impact of Time Until Expiration
The graph has three curves, each representing options with different times to expiration:
- 30 Days (Purple Curve):
- Options with more time until expiration have the highest Vega.
- These options are more sensitive to changes in implied volatility because there's more uncertainty about future price movement.
- 15 Days (Red Curve):
- Vega is smaller compared to the 30-day options. As expiration approaches, the impact of volatility on the option's price diminishes because there’s less time for volatility to make a difference.
- 5 Days (Yellow Curve):
- These options have the smallest Vega. With so little time left, implied volatility changes have minimal effect on the price.
What This Means for Traders
- Long-Dated Options (30 Days or More):
- High Vega can work to your advantage if you expect an increase in volatility. For example, buying options with higher Vega before an earnings report can pay off if volatility rises.
- Short-Dated Options (5-15 Days):
- Vega becomes less important because time decay (Theta) plays a much bigger role.
- Selling options close to expiration can benefit from lower Vega because volatility changes won't significantly impact prices.
Practical Applications
- Straddles and Strangles:
- Traders often use high-Vega, long-dated options to profit from potential large moves in implied volatility.
- Event-Driven Trades:
- Before events like earnings or news announcements, implied volatility spikes, and Vega increases at-the-money.
- After the event, volatility drops (a "volatility crush"), causing Vega to shrink, and options lose value quickly.
- Avoiding Low-Vega Options:
- Options with only a few days left (yellow curve) are less impacted by volatility, so focusing on them for Vega-driven strategies might not be effective.
Vega Summary
- At-the-money options always have the highest Vega.
- Longer expiration = higher Vega. This means they are more sensitive to changes in volatility.
- As options approach expiration, their Vega decreases, and other factors like Theta (time decay) take over as the dominant influence.
By understanding how Vega works, you can better align your strategies with market conditions, especially when implied volatility is expected to change.
Advanced Nugget:
- Volatility Skew:
- Out-of-the-money puts often have higher implied volatility than calls due to market hedging behavior.
- Example: In bearish markets, traders buy protective puts, increasing their implied volatility and, hence, their Vega.
Real-World Application:
- If earnings are approaching for a stock, implied volatility typically rises, boosting Vega.
- Advanced traders use strategies like straddles or strangles to capitalize on this pre-event volatility spike.
Part 3: Rho – Sensitivity to Interest Rates
Basic Concept:
- Rho measures the sensitivity of an option's price to changes in interest rates.
- Call options have a positive Rho; put options have a negative Rho.
Advanced Nugget:
- LEAPS Sensitivity: Longer-dated options are more sensitive to changes in interest rates.
- Example: In a rising interest rate environment, the cost of carrying stock increases, favoring call options and slightly pressuring puts.
- Practical Use Case:
- Rho becomes more interesting when trading LEAPS or when interest rates are expected to shift significantly.
- Advanced traders may use Rho to adjust expectations in macroeconomic environments.
Practice
- Beginner Challenge:
Look at a few option chains on stocks you follow and identify high Gamma and Vega strikes. - Advanced Scenario:
You hold an at-the-money call with 30 days to expiration, and implied volatility is about to spike due to earnings. How would you adjust your position if you expect IV to collapse post-earnings?