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How Option Premiums Adjust With Market Volatility?

One of the most frequently asked questions today is, what the best way to deal with market volatility? Although, high volatility should act as an opportunity for vanilla option traders, they are mostly challenged by the lack of understanding, how the option premiums are impacted with the change in the Implied Volatility.

In today’s article we shall break that jinx and discuss how retail traders can use Option Greeks to solve this challenge.

To begin with, let us first understand the options delta (Δ). We all know that, Δ captures the rate of change of option price with respect to the price of the underlying asset. In essence, Δ is actually measuring the slope of the curve that connects the option price to the underlying asset.

Take for example, you are standing at a bus stop with a speed gun and a bus whizzes past at 90KMPH. The speed gun will immediately tell you that the speed of the bus was 90KMPH. Now imagine you have boarded the bus. Now you use the same speed gun, and the bus is travelling at 90KMPH. The speed gun will tell you that the relative speed of the bus is zero. The question is why?

In the first case, you were standing at the bus stop; therefore your speed was zero. So compared to your speed, the bus was at 90KMPH. In the 2nd case, since you are inside the bus, your speed is also the same as the bus. Hence the speed gun shows a relative speed of zero. Now imagine you start running inside the bus. What you have just done is added a twist to this simple story. You’ve incorporated Implied Volatility in this equation. Therefore, the speed gun will incorporate the change in the magnitude of your velocity and adjust the relative speed accordingly. That is exactly how the Delta of an option is correlated to the Implied Volatility at any given time.

The options gamma (Γ) is also an important indicator. The Γ measures the rate of change of Δ. In our case, we can imagine Gamma as the quantum of momentum generated depending on the magnitude of our velocity inside the bus. This is what adds a twist to the options story. If the Γ is small, Δ will readjust slowly. However, if the absolute value of Γ is large, then the Δ drift is highly sensitive to the price of the underlying. This is what, market makers measure, to gauge the possibility of trend continuation or reversal.

Take for example, under normal circumstances, when Nifty moves from 17,500 to 17,800, then, a specific Call option premium must move from C to C1. However, during a high volatile scenario, when market moves from 17,500 to 17,800, the same Call option premium jumps from C to C2. The expansion or contraction of the spread between C1 and C2 decides whether the market direction should continue or reverse. The reversal point depends on coefficient of the curvature between the option price and the underlying.

Hence it is fair to conclude, that when IV rises or falls sharply, it will impact the Γ curvature leading to an expansion or contraction in the spread between C1 and C2. This in turn will offer a leading edge to option traders in catching the zone of reversal or trend continuation.

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