Options Theory and Physics!
Level 1 - Zero to Options Hero - Unveiling the Hidden Ties
Welcome to a captivating edition of our newsletter, where we delve into the wondrous world of options theory, physics, and the enthralling journey of a ball rolling down a mountain. Buckle up as we embark on a voyage that unites these diverse domains and sheds light on intriguing parallels. This article ties in to the previous Zero to Options Hero Series articles on the Greeks (specifically delta, gamma, and vega) which can be found here and here.
Options Theory and Physics: A Symphony of Concepts
In a surprising twist of fate, options theory and physics share a profound connection. As we explore the interplay between delta (velocity) and gamma (acceleration) in options, we are reminded of the motion of objects in the physical world. Embrace this analogy to elevate your understanding of financial markets.
Delta and Gamma: A Kinship with Velocity and Acceleration
Just as velocity (delta) and acceleration (gamma) define the movement of objects, they govern the dynamics of financial instruments in the realm of options. Delta indicates how fast an option's price changes concerning the underlying asset's price - a true reflection of velocity. Meanwhile, gamma showcases the rate at which delta changes concerning the movements in the underlying asset's price - reminiscent of acceleration.
Newton's Second Law in Options Trading: PNL and the Equations of Motion
Strikingly, Newton's Second Law finds an unexpected home in options trading. By transforming "s = ut + 1/2 at^2" into "pnl = delta * ds + 1/2 * gamma * ds^2," we uncover a hidden treasure trove of wisdom. The pnl (profit and loss) of an option mirrors the position of an object in motion, influenced by both velocity (delta * ds) and acceleration (1/2 * gamma * ds^2).
Vega and Gamma: A Tale of Potential and Kinetic Energy
Now, let's incorporate the mesmerizing journey of a ball down a mountain into our exploration. Just as the ball possesses potential energy while perched atop the mountain, a long-dated option brims with potential energy (Vega) due to the impact of volatility on its price.
As the ball begins its descent, potential energy converts into kinetic energy. Similarly, as time rolls by, the Vega of a long-dated option gradually transforms into kinetic energy (Gamma). The approaching expiration, akin to the ball nearing the mountain's base, marks the shift from Vega-dominated dynamics to Gamma taking center stage.
By embracing the intriguing parallels between options, physics, and mountainous adventures, you gain a unique perspective on options trading dynamics. Understand the conversion of potential energy (Vega) to kinetic energy (Gamma) and the symphony of delta and gamma, and you'll be better equipped to navigate the ever-changing terrain of financial markets.
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