Greeks Are Coming

(A.) Introduction

This paper provides a discussion on the meaning and importance of Greeks in options trading. The following options are covered “Delta”, “theta”, “Gamma”, “Rho” and “Vega” which contribute to options pricing.

This submission is part of the Pre-Module Assignment for the Advanced Treasury Management – Financial Engineering module as part of MSC 25 course.

(B.) Main Body

Derivatives consisting of futures and options are trading instruments whose value is based on an underlying asset. The value of an option is the premium i.e. the price paid by the option buyer. The premium has 2 components (a) The Intrinsic Value = Difference between Strike Price and the Underlying Price (b) Time Value = Number of days to expiry

It is quite evident that the price of an option will be impacted by the following in the order of magnitude.

1. Strike Price:

Difference between the prices (Strike & Underlying) will determine if the option is ITM, ATM or OTM. The deeper an option is ITM, the greater its premium will be; conversely the deeper an option is OTM, the cheaper its premium.

2. Underlying Price:

The premium is affected by price movements in the underlying instrument. For a Call Option- the right to buy the underlying at a fixed strike price – as the underlying price raises so does its premium; as the underlying price falls so does the cost of the option premium fall.

3. Time to expiry:

All other factors being equal the longer an option has to expiry, the greater the chance the price of the underlying will move in the holder’s favor. This means the greater the time to expiry or duration, the higher the premium or cost of option.

4. Interest Rate:

In general interest rates have least influence on options and equate approximately ot the cost of carry of a futures contract. The influence of interest rates on the price is significant only for large contract sizes. The relationship can be thought of as an opportunity cost. In order to buy an...