Friday, September 2, 2011

reflexes about the big 5 parameters in option valuation

Introducing the cast

+ val i.e. premium -- option valuation, manifested in bid/ask
+ vol -- implied vol assuming 30 days to maturity
+ delta -- by far the most important sensitivity. All other greeks pale in significance, though vega and gamma are important.
+ strike
+ spot -- underlier spot price
- one more ... leverage - ratio of spot/val , typically 2 to 200. Measures how expensive an insurance this is. See http://www.tradingblock.com/Learn/public/ShowLearnContent.aspx?PageID=28 and my blog post http://bigblog.tanbin.com/2011/10/option-premium-should-be-low-cost.html Note delta is the first derivative of val against spot, comparable to the inverse of this ratio.

For a given option, these 5+1 variables move in tandem. They are intricately linked but not by a simple math formula. When an experienced trader sees a subset of these numbers, she has a reflex about the level of other numbers i.e. their actual values. This reflex is important. Val, Vol, Delta, Spot are actively monitored.

Unrealized PnL is derived from Val. VaR depends on Delta. Major decisions are made when these "risk" numbers become unacceptable.

In this list i have excluded many well-known parameters (omitted), and introduced a few unsung heroes. I feel this is a real list of important numbers we should master. http://www.ivolatility.com/calc/ lets us see how changes in some numbers come with corresponding changes in others.

Here are some Examples from P24 [[Option Vol Trading]] -

--XOM
Val = $6.50
Spot = $77
Strike = $75 ITM
Delta ~= 60%
leverage = 77/6.5 = 12 times
Vol ~= 52% according to http://www.ivolatility.com/calc/ assuming 48 days to maturity

--FCX
Val = $6.50
Spot = $24
Strike = $20 ITM
Delta ~= 75%
leverage = 24/6.5 = 4 times
Vol ~= 103% assuming 84 days to maturity

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New York (Time Square), NY, United States
http://www.linkedin.com/in/tanbin