1) Hedging: A hedge is like an insurance policy in that it can help mitigate risk for a small fee. For example, a portfolio manager buys a large position in Company A stock for its long-term price appreciation potential but is worried that the next report will show short-term issues. He or she can buy put options on that stock that will increase in value if the price of the stock falls on its news.
2) Speculation: Options allow both buyers and sellers to capitalize on their market forecasts, whether they are , , or neutral. However, because options prices depend on many factors, including market , traders can profit from increases or decreases in those factors as well.
While traders can look at individual options data, a very widely used display called an “options chain” lists all options, or a subset, available for a given expiration month. Options traders also look at derivatives of the price that measure how fast their prices decay over time, how fast their prices change with a given change in the price of the underlying, and more. These derivatives are designates with Greek letters such as delta and gamma, so traders call them “the Greeks”.
I. Delta – measures how much an option price changes for a one-point move in the underlying. Its value ranges between 0 and 1 for calls and between -1 and 0 for puts.
II. Gamma – measures the in delta. It is essentially the second derivative of price.
III. Vega – measures the risk from changes in implied . Higher vol makes options more expensive since there is a greater change than the underlying security price will move above the strike price for a call.
IV. Theta – measures the rate of time-value decay and is always a negative number as time moves in only one direction.
V. Rho – measures the impact of changes in interest rates on an option’s price.
Implied (IV) is the estimated of a security’s price and is critical in the pricing of options. Although not a guarantee, implied tends to increase while the market in the underlying security is . Conversely, when the underlying security is , implied tends to decrease. This is due to the common belief that bear markets are riskier than bull markets.
The most important is that implied is an estimate of the future , or fluctuations, of a security’s price. While levels of implied are associated with and markets in the underlying security, it really does not predict market direction. It only forecasts the sizes of potential price swings. Implied is not the same as , also known as realized or actual . measures past market changes in the price of the underlying asset.
Trade with care.
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