Tag: risk management strategy

  • Greeks In Trading Options As A Risk Measure

    Greeks In Trading Options As A Risk Measure

    Greeks In Trading Options As A Risk Measure
    Using Greeks in trading options can confuse a trader but can be extremely helpful. 

    By Guy Avtalyon

    Greeks in trading options can provide helpful information, but also they can add a bit of complexity that can confuse options traders. Greeks in trading are a measure of how some option’s price is sensitive to its basic parameters, volatility, or price of the underlying asset. This measure is important when you analyze the sensitivity of your options’ portfolio or single option. So many traders and investors think this is a vital measure for decision making in options trading.

    The key Greeks are Delta, Gamma, Vega, Theta but some will include Rho too. Also, you’ll find some other Greeks derived from these four or five.

    Greeks in trading options can indeed hide the most important part, the difference between the stock price and strike price and the value decrease with reducing time to expiration on the option. For these reasons some options traders never examine the Greeks at all when making trades. But they are important and we will show you why.

    The importance of Greeks in trading options

    It isn’t easy to have an accurate prediction of what is going to happen to the price of the option especially when the market is moving. Even more difficult can be to predict the options positions that efficiently couple multiple individual positions. That is the case with options spreads, for example. 

    The problem is that most options trading strategies require the spreads, anything that can help you to predict the option position is important and you have to know them better. These measures can be very useful when you have to predict the future of the option price since they measure the sensitivity of a price related to the price of the underlying assets, interest rates, volatility, and time decay. By having all this information you can be in a much better position because you will know when and which trades to make. 

    How is that possible?

    The Greeks in trading options will provide you a hint of how the price of your options will run related to how the price of the underlying asset changes. Also, the Greeks will help you forecast how much time value an option is losing daily. Moreover, by using Greeks in trading options you will have a valuable tool for risk management. In other words, you can use these measures to understand the risk for each position and where the risk will appear. Greeks will help you to recognize which risk factors you have to remove from your position and your positions’ portfolio. Also, they can show you how much hedging you need for that. 

    Keep in mind, you can use Greeks as an indicator of how the price will go related to different factors but they are theoretical. To make this more clear, Greeks are actually values based on mathematical rules and can be accurate only if they are calculated according to the exact mathematical model.

    How to calculate Greeks?

    It is possible to do yourselves but, we have to warn you, the process is complex and you’ll need a lot of time for that. Usually, traders use some software to do that for them and get accurate calculations. The serious online broker will automatically present values for the Greeks in the options they display. That makes the use of Greeks in trading options a lot easier.

    Anyway, we will show you how to calculate the four most popular Greeks.

    Calculate Greek Delta

    Delta, the sign is Δ, can measure the sensitivity of price changes related to the moves in the price of the underlying assets. So, for example, when the price of the underlying asset grows by some amount in money, the price of the option will change by Δ amount. Here is the formula to calculate that Δ amount

    Δ = ∂V/∂S

    ∂  represents the first derivative
    V  represents the option’s price which is the theoretical value
    S –represents the price of the underlying asset

     Why did we take the first derivative of the option and price of the underlying asset? Because the first derivative is a measure of the rate change of the variable over a determined period.

    The delta is visible as a decimal figure from -1 to 1. For example, call options will have a delta from 0 to 1, but puts will have a delta from -1 to 0. We have to point one important thing here, to give you a better perception of how to understand Delta numbers. When you see the option’s delta is close to 1 or -1, you will know the options are deep-in-the-money.

    Also, you can calculate delta for your options’ portfolios. It is the weighted average of all deltas of options added to the portfolio. As one of the Greeks, delta can be a hedge ratio, also. When you know the amount of delta, you can hedge your position if you buy or short the number of underlying assets multiplied by delta. It’s quite simple, don’t you think? 

    Gamma as one of the Greeks in trading options

    Gamma or Γ is a measure of the rate of change of its delta per 1-point move in the price of the underlying stock.

    The formula to calculate is expressed as:

     Γ = ∂Δ/∂S = ∂2V/∂2S

    The gamma can be expressed as a percentage also. And as same as delta, gamma is changing even with very small moves of the underlying asset price. Gamma is at its peak when the asset price is near to strike price of the option. It drops when the options go deeper out of or into the money. When the option has gamma value close to 0 that means it means the option is very deep out of or into the money. 

    Long options will have positive gamma values. When the options strike price is equal to the price of the underlying stock gamma will have the maximum value.

    One of the Greeks in trading options is Vega

    Vega or ν is also an option Greek. It measures the influence of changes in the underlying volatility on the option price. In other words, it measures the sensitivity of the option price in comparison to the volatility of the underlying stock. Vega will show the change in the price of the option for each change in underlying volatility, for every 1% of it.

    Here is the calculation:

    ν = ∂V / ∂σ

    ∂  represents the first derivative
    V  represents the option’s price  which is the theoretical value
    σ  represents the volatility of the underlying asset

    The vega is shown as a money amount.

    Options will be more costly when volatility is higher. So, when volatility rises, the price of the option will rise too. Consequently, when volatility decreases, the price of the option will drop also. Hence, when you want to calculate the new option price caused by volatility changes, you have to add the vega when volatility goes up. This means, to subtract it when the volatility decreases.

    Theta

    Theta symbol is θ. It is a measure of the sensitivity of the option price relative to the option’s time decay. If the date of expiry is closer by one day, the option’s price will change for the theta value. The theta is related to the option’s time to maturity.

    The formula is:

    θ = ∂V / ∂τ

    ∂ represents the first derivative
    V is the option’s price in sense of theoretical value
    τ represents the option’s time to maturity

    Generally speaking, the theta is expressed as a negative figure and it is negative for the options. Well, for some European options it can be positive. This is possible because theta describes the most negative value when the asset is at-the-money and shows the value by which the option’s price will decrease every day.

    Long-term options will have theta of near 0 because they do not lose value daily. Hence, theta is higher for short-term options, particularly at-the-money options. The reason is that short-term options have more premiums and a chance to lose every day. Theta will dramatically increase when the option is near to the date of expiry and time decay is greatest during those periods.

    Rho

    Rho or ρ. It measures the sensitivity of the option price related to interest rates. When a benchmark interest rate rises by 1%, the option price will switch by the rho value. The rho isn’t too important as other  Greeks are. Interest rates don’t have such a big influence on option prices and they are less sensitive to interest rate changes.

    Nevertheless, here is the formula to calculate:

    ρ = ∂V / ∂r

    ∂ is the first derivative
    V is the option’s price meaning the theoretical value
    r is the interest rate

    The call options will have a positive rho, but the rho for put options will be negative.

    Why using Greeks in trading options?

    In real trading, the Greeks will all change and develop their changes over the other variables. Every single change in the underlying asset’s price, interest rates, the expiry date may influence all variables simultaneously. So, it’s a smarter decision to use some software to calculate the final result.

    But it is very important to know why and how the Greeks can help and provide you a measure of position’s risk and reward. When the Greeks in trading options become familiar to you, apply them to your trading strategies. It is necessary to use all types of risk-exposure measures. This may bring your options trading to a higher level.

    Meanwhile, learn more about pattern trading from the “Two Fold Formula” book and check it with the our preferred trading platform.

  • Risk Management Strategy For Buying Stocks

    Risk Management Strategy For Buying Stocks

    Risk Management Strategy For Buying Stocks
    Risk management is the most important thing that you can learn if you want to trade stocks. That will provide you with staying in the game.

    By Guy Avtalyon

    A risk management strategy for buying stocks means you have a plan. It seems a bit fishy to suggest that you can simply search for  “high yield” and “low risk” and find trading opportunities that will beat the odds in the stock market for sure and do it with minimum risk. If it is so simple, why do we have losing trades? How is it possible that no one is doing that?  What forces you to choose low yield stock with high risk? Must we really be a genius to be able to find a risk management strategy for buying stocks?

    To be honest, smart trading or investing isn’t that simple. In other words, buying stocks requires a risk management strategy among other things. 

    Risk management for some unknown reasons is low placed on the list of the priorities for the majority of stock traders. Every single trader would rather seek the best indicator than to create a risk management strategy for buying stocks. There is no reason to put this very important issue so low. It is the opposite. 

    A risk management strategy for buying stocks has to be on the top of a stock trader’s priorities. Without knowledge about risk management, no one can be a profitable trader. As a trader, you must understand how to manage your risk, how to size your position, how to set the orders accurately. 

    Of course, only if you want to be a profitable trader. In case you don’t stop reading this. For those who want, here is a risk management strategy for buying stocks. Actually, several suggestions. 

    What is a risk management strategy for buying stocks?

    A risk management strategy for buying stocks helps to lower losses. If you have a risk management strategy or you improve it, you’ll avoid most of the problems that can arise and cause you to lose money.

    One of the tips is, determine where you will set your stop loss and take profit order but before you enter the position. At the same moment when you find a good entry point, you have to decide where you’d set these important levels: stop loss and take profit points.

    When you have recognized the right price levels for your orders, you have to measure the risk/reward ratio. If it doesn’t match your goals, stay away from the trade. Never try to stretch your take profit order or squeeze your stop loss to reach a higher risk/reward ratio. Keep in mind that the reward is always potential, it isn’t 100%-sure. What you can control for sure is a risk. 

    Yes, we know very well some beginners in stock trading who do this thing totally opposite. They think it is possible to randomly find a risk/reward ratio and then adjust stop loss and take profit orders to reach the desirable ratio. Well, it is possible but what really you’ll get is a losing trade.

    Can a trader who has made solid profits waste it all in one bad trade?

    Yes, it is particularly true if you don’t have a proper risk management strategy for buying stocks. 

    Failed traders enter a trade without having any idea of break-even stops or what does it mean at all. Somewhere and somehow they picked that phrase and wanted to implement. Please, avoid it. First of all, if you move the stop loss to the level of your entry wanting to create a trade without losses you are entering one of the most dangerous trades. Moreover, such a trade will often end up as unprofitable. Yes, you have to protect your position but this tactic is going to put you into various problems. It is particularly true if you base your trades on technical analysis. How is that possible? Your entry point is very often evident for other traders too. So many of them will have the same or similar entry point. And what can happen? Well, the elite traders will eat you. 

    For example, you enter a short trade when support breaks, and the stop loss point is above the support level. But you move your stop loss to a break-even point in order to protect your trade. What happened? The price goes back into support and takes out your stop loss. Support held but you miss profits. Yes, support validated your trading idea but your risk or, in this case, stop loss management fired you out. You moved too soon. That’s a possible danger which amateurs almost never notice. One bad trade and you lost all your money.

    Set stop-loss points more effectively

    You can do this by using technical analysis, but fundamental analysis can help in timing. For example, you are holding a stock ahead of earnings and drama grows. But you may want to sell before expectations become too high. Use the moving average. For experienced traders, it is maybe the most popular method to set stop loss and take profit points. It’s easy to calculate. Main averages are 5-days, 9-days, 20-days, 50-days, 100-days, and 200-days moving averages. Just apply them to your chart and check how the stock price reacted to them previously, both as support or as a resistance level.

    Also, you can set stop-loss or take-profit levels on support or resistance trend lines. Just connect the prior highs or lows that befell above-average volume. The point is to find the levels at which the stock price responded to the trend lines and on volume. For more volatile stocks use a long-term moving average. This will minimize the possibility of an unimportant price move to execute your stop-loss order before it’s time. 

    Also, you have to adjust moving averages to your target price. For long targets use longer averages. In this way, you’ll reduce the number of generated signals. This will reduce the noise too. If the stock price is changing too much it is the sign of high volatility, set a stop loss adjusted to the market’s volatility. The great help is to know when some major event may occur. For example, earnings reports can be a good time to be in or out of the trade because the volatility can arise.

    Pay attention to extremely low P/E stocks as a risk management strategy for buying stocks

    Don’t think that playing the stock market is easy. Beating it is more difficult. All you need is to find a stock that is trading at fantastic bargain levels. Well, how to find such opportunities?

    One way is to use the P/E ratio. Calculate it by dividing the share price by the number of earnings per share. If the stock is making a high-profit but its share price is low, the stock is undervalued. Beginners may think it is a good opportunity but if they never calculate the P/E ratio they could increase their risk.

    A trick of finding low-priced stocks

    For example, the stock made $4 per share of profit last year. But this stock is still cheap, its share price is $8 and the P/E ratio is, for example, 4. The average P/E ratio for the industry is, let’s say, 16. And you may think this stock should be trading at least over 4 times higher based on this ratio. But remember, that is just one single ratio. 

    This stock doesn’t have such a low P/E ratio without the reason. For example, the earnings are unsteady and the company may have problems paying a debt. So, the stock can be cheap if you look at the P/E ratio as a sole metric but traders noticed an increased risk and volatile stock. That affected its share price and the stock is trading at a lower price with the possible high risk involved.

    So, you’ll need to analyze other earning ratios or numbers. For example, compare the company’s share price to its cash flow per share. Find the industry average.  Only than you’ll if the stock is fairly valued. One note more, if the company boasts a low P/E ratio, be cautious. There is an added risk.  

    Traders-Paradise wants to show you how to do smart trading. A risk management strategy for buying stocks is one of the most important parts of trading. As far as you learn this, the more successful your trades will be.Â