Bossu S Vs Presentation Chicago 2007

24 February 2007
Introduction to Volatility Trading and Variance Swaps

EQUITY DERIVATIVES WORKSHOP
University of Chicago — Program on Financial Mathematics
Sebastien Bossu
Equity Derivatives Structuring — Product Development
0
Disclaimer
This document only reflects the views of the author and not necessarily those of Dresdner Kleinwort research, sales or
trading departments.
This document is for research or educational purposes only and is not intended to promote any financial investment or
security.
1
Volatility Trading and Variance Swaps
Introduction
Typical Trading Floor — Instruments
‘Cash’
Exotics
Futures Options
2
Introduction
Typical Trading Floor — Front Office
Trading
Structurers Quants
/ Financial
Engineers
Marketing Research
/ Sales Economists
3
►Key concepts behind Black-Scholes............................................................. 5
►Black-Scholes in practice ............................................................................12
►Managing an option book ........................................................................... 21
►Trading volatility .......................................................................................... 27
►P&L path-dependency ................................................................................ 39
►Variance swaps ...........................................................................................45
4
Key concepts behind Black-Scholes
► Why is Black-Scholes used in practice?
► Key strengths
► Key limitations
5

Why is Black-Scholes used in practice?
Derman: ‘In 1973, Black and Scholes showed that you can manufacture an IBM
option by mixing together some shares of IBM stock and cash, much as you can
create a fruit salad by mixing together apples and oranges. Of course, options
synthesis is somewhat more complex than making a fruit salad, otherwise
someone would have discovered it earlier. Whereas a fruit salad's proportions stay
fixed over time (50 percent oranges and 50 percent apples, for example), an
option's proportions must continually change. [...] The exact recipe you need to
follow is generated by the Black-Scholes equation. Its solution, the Black-Scholes
formula, tells you the cost of following the recipe. Before Black and Scholes, no
one ever guessed that you could manufacture an option out of simpler ingredients,
and so there was no way to figure out its fair price.’
My Life as a Quant, John Wiley & Sons, 2004
6

Key strengths
►Sensible model for the behavior of stock prices: random walk / log-normal diffusion
►Intuitive parameters: spot price, interest rate, volatility
►Arbitrage argument: dynamic hedging strategy
7

Key limitations
►True or False?
‘Stock prices follow a random walk / a lognormal diffusion’
►False – Stock prices are determined by supply and demand which are influenced
by countless economic factors. If a company announces bankruptcy, its stock price
WILL go down with 100% probability.
8

Key limitations
►True or False?
‘If I buy an option at a higher price than ‘the’ Black-Scholes price, I will lose
money.’
►False – Different agents have different uses for options:
►Bets: individual investors, asset managers
►Hedging: corporate investors
►Volatility trading: traders, hedge funds
i.e Black-Scholes is not an arbitrage price in the sense that one loses money when trading at a
different level (compared to forward contracts / futures where there is a ‘strong’ (static) arbitrage.)
9

Key limitations
►True or False?
‘If I buy an option at a price higher than ‘the’ Black-Scholes price and I follow ‘the’
Black-Scholes delta-hedging strategy, I will lose money.’
►False but in one case:
►False in practice: discrete hedging, jumps, stochastic volatility may have a

positive impact on P&L
►False in theory: even if we assume that the realised stock price process is a log-
normal diffusion…
►…unless we also assume that the realised stock price process follows a log-
normal diffusion with the same volatility parameter as the one used to price the
option
10
10

So what is Black-Scholes?
►NOT a good model for the real behavior of stock prices
►NOT a good model to determine the ‘fair value’ of an option: different agents give
different values to the same option
►NOT a good model to arbitrage option prices: too many factors are ignored
►BUT a powerful, simple toy model to:
►Understand which factors influence the price of an option and estimate its
manufacturing cost
►Interpret a market quote (more on this in the next section)
11
11
Black-Scholes in Practice
► Implied Volatility
12
Input/Output Diagram
Spot Price
Strike Price
Maturity Black Scholes Option Price
Interest & Dividend

Rates
Volatility
13
13
Implied Volatility Diagram
Spot Price
Strike Price
Maturity Black Scholes Option Price
Interest & Dividend

Rates
Volatility
14
14
Implied Volatility Example: S&P 500 Dec-08 options
Source: Bloomberg. Data as of 18 October 2006.
15
15
Implied Volatility Example: S&P 500 Dec-08 options
Implied volatility
24%
22%
20%
18%
16%
14%
12%
800 1000 1200 1400 1600 1800
Source: Dresdner Kleinwort.
16
16
Implied Volatility Smile and Term Structure
►Implied Volatility Smile (or Skew)
►In Black-Scholes the volatility parameter is assumed to remain constant

through time…
►… in practice every option expiring at time T has a different implied volatility

depending on its strike K
►Implied Volatility Term Structure
►Also every option struck at level K has a different implied volatility depending on
its expiry T.
17
17
Implied Volatility Surface
smile implied volatility
Implied volatility surface
24% 60%
22%
20% 50%
18%
16% 40%
14%
30%
12%
800 1000 1200 1400 1600 1800
20%
+ term structure = 10%
ATM Implied volatility

0%
331
20%
680
18%
968
16%
1083
14%
1198
12%
1290
10%
1348
8%
1429
6% 17-Nov-06
1544
4% 17-Oct-07
1659
2%
16-Oct-11
1970
0%
2831
Oct-06 Oct-07 Oct-08 Oct-09 Oct-10 Oct-11
18
18
Reasons for Implied Volatility
►In the early days options often had the same implied volatility. After the October
1987 crash, volatility surfaces appeared. Why?
►Stock prices do not follow the log-normal diffusion postulated by Black-

Scholes. Mainly: volatility is itself volatile, jumps can occur! In particular,
stock prices and volatility are negatively correlated: when the market goes
down, volatility goes up
►Delta-hedging cannot take place continuously, transaction costs can be

significant.
►From a fundamental value perspective, implied volatility can be seen as a market

adjustment to take into account everything which Black-Scholes does not.
►From a relative value perspective, implied volatility has become the standard
measure to compare option prices, in a similar way as yield for bonds.
19
19
Reasons for Implied Volatility: Evidence of Equity Skew
12 change in S&P 500 implied volatility
10
2
daily return
0
-8.00% -6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00%
-2
-4
-6
-8
-10
SPX Index linear regression
20
20
Managing an Option Book
► Greeks
► Hedging
21

Definition of an Option Market-Maker
►The job of an option market-maker is to provide liquidity to option buyers and

sellers while securing her margin (bid-offer). Thus she will try to minimize the
impact of market factors on the mark-to-market of her option book to make it as
close as possible to a risk-free portfolio.
►Typical factors:
►Change in spot price: small & large
►Change in implied volatility
►Passage of time
►Change in interest rate
►Change in dividends.
22
22

Greeks
►The change in option price f resulting from a change in one factor is named
sensitivity or ‘Greek’:
∂f
Δ= Delta Change in f due to (small) change in spot price
∂S
∂2 f Second-order change in f due to (large) change in spot
Γ= 2 Gamma
∂S price = Change in Δ due to change in spot price
∂f
V= Vega Change in f due to change in implied volatility
∂σ
∂f
Θ= Theta Change in f due to passage of time
∂t
∂f
ρ= Rho Change in f due to change in interest rate
∂r
∂f
μ= Mu Change in f due to change in dividends
∂q
23
23

Greeks at Book Level
►By linearity of differentiation, the Greeks of an option book are equal to the sum of
the individual Greeks multiplied by the positions. For example:
►Book = Long 1,000 Option 1 and Short 500 Option 2
►Book Value = 1,000 x Price 1 – 500 x Price 2 (‘mark-to-market’)
►Book Delta = 1,000 x Delta 1 – 500 x Delta 2
►Etc.
24
24

Hedging
►The standard approach to minimize the impact of market factors on the mark-to-
market of an option / a book of options is to offset (‘hedge’) the Greeks with a
relevant instrument
►Example: Delta-hedging
►Initial Book Delta = $5,000 per S&P 500 index point
►Delta-hedge = Sell 5,000 units of S&P 500
►Final Book Delta = 0. This means that the book mark-to-market value is
immune to (small) changes in the level of S&P 500.
25
25

Hedging
►To hedge other Greeks than Delta (e.g. Gamma, Vega…) our market-maker must
trade other instruments.
►However, it is usually impossible to perfectly hedge all Greeks.
►This implies that the market-maker is left with some risks.
►Her job is to design her option book so as to be left with the risks she is
comfortable with (e.g. long Vega if she believes volatility is on the rise etc.).
26
26
Trading Volatility
► Where does volatility appear in Black-Scholes?
► Daily option P&L equation
► Volatility trading equation
27
Trading Volatility
Definition
Taleb: ‘Volatility is best defined as the amount of variability in the returns of a

particular asset. [...] Actual volatility is the actual movement experienced by the
market. It is often called historical, sometimes historical actual. Implied volatility is
the volatility parameter derived from the option prices for a given maturity.
Operators use the Black-Scholes-Merton formula (and its derivatives) as a
benchmark. It is therefore customary to equate the option prices to their solution
using the Black-Scholes-Merton method, even if one believes that it is
inappropriate and faulty, rather than try to solve for a more advanced pricing
formula.’
Dynamic Hedging: Managing Vanilla and Exotic Options, John Wiley & Sons, 1997
28
28
Trading Volatility
Definition
Historical (‘Realised’) Volatility Implied Volatility
►Annualized standard deviation ►Volatility parameter in Black-Scholes
of daily stock returns: model of stock prices (random walk /
lognormal diffusion):
252 N
σ Historical = ∑
N − 1 t =1
(rt − r ) 2 dS t
= μdt + σ Implied dWt
St
where:
N
S 1
rt = ln t
St −1
r=
N
∑r
t =1
t
29
29
Trading Volatility
Implied vs. Realised
►True or False?
‘An option market-maker sold a call at 30% implied volatility and delta-hedged
her position daily until maturity. The realised volatility of the underlying was
27.5%. Her final P&L must be positive.’
►False – The trading P&L on a delta-hedged option position is ‘path-dependent.’
30
30
Trading Volatility
Where does realised volatility appear
in Black-Scholes?
►Consider the Black-Scholes Partial Differential Equation:
∂f 1 2 2 ∂ 2 f ∂f
rf = rS + σ S +
∂S 2 ∂S 2 ∂t
►With Greek notations:
1
rf = rS × Δ + σ 2 S 2 × Γ + Θ
2
►What is σ? σRealised or σImplied?
31
31
Trading Volatility
Where does realised volatility appear
in Black-Scholes?
►Remember that Black-Scholes derive ‘the’ price of an option by modelling the
behaviour of an option market-maker who follows a delta-hedging strategy.
►In this idealized world there is only one volatility:
σRealised = σImplied = σ
►In reality traders tweak the model through the volatility parameter to make up for
the model imperfections. As such they don’t believe in the model, they merely
use it.
32
32
Trading Volatility
Daily option P&L equation
►The daily P&L on an option position can be decomposed along the Greeks:
Full Daily P&L = Delta P&L + Gamma P&L + Theta P&L + Vega P&L + Rho P&L +
Mu P&L + Other
►Other = high-order sensitivities (e.g. sensitivity of Vega to a change in the spot

price…)
33
Note that Delta P&L, Gamma P&L and Theta P&L correspond to the ‘state variable risks’ modelled in
Black-Scholes, while the Vega P&L, Rho P&L, Mu P&L etc. correspond to ‘parametric risks’ which
are not modelled in Black-Scholes. A more sophisticated model such as stochastic volatility with
jumps would transfer some parametric risks (Vega) to the state variable risks universe, leading to
different Greeks than Black-Scholes.
33
Trading Volatility
►Assuming constant volatility, zero rates and dividends, and ‘Other’ is negligible, we
obtain the reduced daily option P&L equation:
Daily P&L = Delta P&L + Gamma P&L + Theta P&L
= Δ x (ΔS) + ½Γ x (ΔS)2 + Θ x (Δt)
where ΔS is the change in stock price and Δt is one trading day (1/252nd).
34
34
Trading Volatility
►For a delta-hedged option position, we have Δ = 0. Hence:
Daily P&L = ½Γ x (ΔS)2 + Θ x (Δt)
►Typically Gamma and Theta have opposite signs:
►For a long call or put position, Gamma is positive and Theta is negative, i.e. the
trader is long shocks/volatility (she makes money as the stock price moves) and
short time (she loses money as maturity approaches.)
►For a short call or put position, the situation is reversed.
35
35
Trading Volatility
►Graph of Gamma vs. Theta

p/l at start of day p/l at close of business
profit
Γ Γ
S
Θ Θ
Θ
loss
36
36
Trading Volatility
Volatility trading equation
►In fact, Theta can be expressed with Gamma through the proxy formula:
1
Θ ≈ − ΓS 2σ Implied
2
2
►Plugging the proxy into the daily option P&L equation:
1
Daily P & L ≈
2
[
Γ (ΔS ) 2 − S 2σ Implied
2
]
× Δt
1 2 ⎡⎛ ΔS ⎞
( ) ⎤⎥
2
2
≈ ΓS ⎢⎜ ⎟ − σ Implied Δt
2 ⎢⎣⎝ S ⎠ ⎥⎦
37
37
Trading Volatility
Volatility trading equation
1 2 ⎡⎛ ΔS ⎞ 2⎤
( )
2
Daily P & L ≈ ΓS ⎢⎜ ⎟ − σ Implied Δt ⎥

2 ⎣⎢⎝ S ⎠ ⎦⎥
►This equation tells us that the daily option P&L on a delta-hedged option position is
driven by two factors:
►Dollar Gamma, which has the role of a scaling factor and does not determine
the sign of the P&L
►Variance Spread (realised vs. implied), which determines the sign of the P&L
►Thus, a trader who is long dollar gamma will make money if realised variance is
higher than implied, break even if they are the same, and lose money if realised
is below implied.
38
‘The Second-Most Important Equation’ in finance according to Derman
38
P&L path-dependency
► Case study
► Path-dependency equation
39
P&L path-dependency
Case study
►An option market-maker sold a 1-year call struck at €110 on a stock trading at
€100 for an implied volatility of 30%, and delta-hedged her position daily until
maturity.
►The realised volatility of the underlying was 27.5%
►2 months before maturity, her P&L was up €100,000
►Yet her final trading P&L is down €60,000
►How did the profits change into losses?
40
40
P&L path-dependency
Case study
►The hard life of an option trader...

Stock price Cumulative P/L (€)
120 160,000
Strike = 110
100 120,000
80 80,000
Stock price
60 40,000
Cumulative P/L
40 -
20 -40,000
Trading days
0 -80,000
0
14
28
42
56
70
84
98
112
126
140
154
168
182
196
210
224
238
252
41
41
P&L path-dependency
Case study
►Realised Volatility and Dollar Gamma

Stock price Volatility
120 60%
Strike = 110
100 50%
40%
80 40%
Stock price
29%
60 50-day realized 30%
volatility
40 18% 20%
20 10%
Dollar Gamma
Trading days
0 0%
0
14
28
42
56
70
84
98
112
126
140
154
168
182
196
210
224
238
252
42
Note that the graph of the dollar gamma actually corresponds to a short position.
42
P&L path-dependency
Path-dependency equation
►Summing all daily option trading P&L’s until maturity, we obtain the path-
dependency equation:
( )
N
Final P & L ≈ ∑ γ t ⎡rt 2 − σ Implied Δt ⎤
2
t =1
⎢⎣ ⎥⎦
where γt = ½ x Γ(t-1, St-1) x St-12 is the Dollar Gamma at the beginning of day t and
rt = (St - St-1)/St-1 is the stock return at the end of day t.
►With this expression, we can clearly see that the final P&L is the sum of the
daily Variance Spread weighted by the Dollar Gamma. Thus, days when Dollar
Gamma is high will tend to dominate the final P&L.
43
43
P&L path-dependency
A path-independent derivative?
►For the final P&L to be path-independent (in the sense of the equation in the
previous page), the Dollar Gamma must be constant.
►This defines a new type of derivative, the log-contract:
c ∂2 f c
γ t = c → Γ = 2 → 2 = 2 → f = c ln S + bS + a
S ∂S S
►Log-contracts are not traded, but they are closely connected to Variance Swaps
introduced in the next section.
44
44
Variance Swaps
► Introduction
► Hedging & Pricing
► Mark-to-Market Valuation
45
Variance Swaps
Introduction
►A variance swap is an exotic derivative instrument where one party agrees to
receive at maturity the squared realised volatility converted into dollars for a
pre-agreed price:
⎡ ⎤
⎢ 252 N ⎛ S ⎞ 2 ⎥
Variance Swap Payoff = $1× ⎢
⎢ N
∑ ⎜⎜ ln
t =1 ⎝ S
t
⎟⎟ − K var ⎥
2
⎥
t −1 ⎠
⎢⎣ 1 4 2 43 ⎥⎦
Squared log − return
where:
►St is the closing price on day t
►N is the number of trading days between the trade date and the maturity date
►252 is the number of trading days in a year
►Kvar is the variance strike expressed in volatility percentage points (e.g. 30%) and
is not to be confused with the strike of a vanilla option which is a stock price level
46
46
Variance Swaps
Introduction
Example Payoff Calculation
►Variance Buyer: [Dresdner] ►Scenario 1
► Realised volatility 20%
►Variance Seller: [‘Sigma LLC’]
► Payoff = $1 x (0.22 – 0.32)
= $-0.05
►Underlying asset: S&P 500
► Thus, the variance buyer (Dresdner) pays 5
►Start date: Today cents to the variance seller (Sigma)
►Scenario 2
►Maturity date: Today + 1yr
► Realised volatility 40%
►Strike (Kvar): 30% ► Payoff = $1 x (0.42 – 0.32)
= $0.07
► Here Dresdner receives 7 cents from Sigma
47
47
Variance Swaps
Introduction
►Note:
►Returns are computed on logarithmic basis rather than arithmetic
►The mean return is not subtracted (‘zero-mean assumption’)
►In practice the log-returns are multiplied by 100 to convert from decimal to
percentage point representation, and the variance strike is quoted in volatility
points (30 for 30%)
►Often the number of variance swap units is calculated from a notional specified
in volatility terms (e.g. $100,000 per volatility point):
Vega Notional
Variance Notional =
2 × K var
48
48
Variance Swaps
Introduction
►Variance Swaps are actively traded on the major equity indices: S&P 500, Nasdaq,
EuroStoxx50, Nikkei...
►Typical bid/offer spread is ½ to 2 volatility points (‘vegas’)

Indic. mids SPX NDX SX5E NKY
Nov-05 15.6 16.7 17.4 17.5
Dec-05 15.2 16.6 17.0 17.5
Jan-06 15.3 17.4 16.9 17.4
Mar-06 15.7 17.9 17.5 17.2
Jun-06 16.2 18.9 17.7 17.6
Sep-06 16.6 19.8 18.0 17.8
Dec-06 16.9 20.4 18.6 18.1
Jun-07 17.4 21.3 18.7 18.6
Dec-07 17.8 21.9 19.3 19.2
Jun-08 18.3 22.3 19.6 19.7
Dec-08 18.7 22.6 19.9 20.1
Dec-09 19.6 23.1 20.3 20.4
Source: Dresdner Kleinwort. Data as of October 2005.
49
49
Variance Swaps
Hedging & Pricing
►Compare the Variance Swap payoff (1) with the P&L path-dependency
equation (2):
2
252 N ⎛ St ⎞
(1) Variance Swap Payoff = ∑ ⎜ ln ⎟ − K var
N t =1 ⎝ St −1 ⎠
2
( )
N
(2) Final Option P & L = ∑ γ t ⎡ rt 2 − σ Implied Δt ⎤
2
t =1
⎢⎣ ⎥⎦
►Substantially, the difference between equations (1) and (2) lies in the weighting of
the squared daily log-returns:
►Variance Swaps are equally weighted
►The final P&L of a delta-hedged vanilla option position is Dollar-Gamma-

weighted
50
50
Variance Swaps
Hedging & Pricing
►Thus, a Variance Swap could be hedged by an option with constant Dollar

Gamma: the Log-Contract
►However, Log-Contracts do not trade in the market
►Problem: Can we find a combination of vanilla calls and puts with the same
maturity as the variance swap such that the aggregate Dollar Gamma is
constant?
►Formally: Find quantities (‘weights’) w1Put, w2Put, ... and w1Call, w2Call, ... such that:
N Put N Call ►Put i struck at KiPut

γ Aggregate = ∑ wiPut γ iPut + ∑ wiCall γ iCall = c
i =1 i =1 ►Call i struck at KiCall
51
51
Variance Swaps
Hedging & Pricing
►Answer: Use weights inversely proportional to the square of strike: wi = 1/Ki2

Dollar Gamma
K = 25
Constant Gamma Region
K = 50
K = 75
K = 100
K = 125K = 150 Aggregate
K = 175 K = 200
0 50 100 150 200 250 300
52
52
Variance Swaps
Hedging & Pricing
►A perfect hedge would require an infinite number of liquid options with strikes
forming a continuum [0, ∞)
►The fair strike of a Variance Swap (i.e. the level of Kvar such that the swap has
zero initial value) is then given as:
2e rT ⎡ 1 1 +∞ 1 ⎤
= ∫ + ∫
*
K var ⎢ 2
Put ( k ) dk 2
Call (k )dk ⎥
T ⎣0k 1 k ⎦
where r is the constant interest rate, T is the maturity, Put(k), Call(k) denote the
price of a put or call struck at k% of the underlying asset’s forward price.
53
53
Variance Swaps
Mark-to-Market Valuation
►Because variance is additive, the mark-to-market valuation of a variance swap

position can be linearly decomposed between past (realised) variance and
future (implied) variance:
⎡t T −t 2 ⎤
MTM t = e − r (T −t ) ⎢ Realized t2 + Implied t2 − K var ⎥
⎣T T ⎦
where:
►Realisedt is the realised volatility between the start date 0 and date t (under
zero-mean assumption)
►Impliedt is the current fair strike of a (notional) variance swap starting on date t
and ending on date T
►Kvar is the strike level agreed on the start date 0
54
54
References & Bibliography
►My Life as a Quant, Emanuel Derman, Wiley (2004)
►Dynamic Hedging: Managing Vanilla and Exotic Options, Nassim Taleb, Wiley
(1997)
►More Than You Ever Wanted To Know About Volatility Swaps, K. Demeterfi, E.
Derman, M. Kamal, J. Zou, Goldman Sachs Quantitative Strategies (1999)
► Self-referencing:
► Introduction to Variance Swaps, Wilmott Magazine (March 2006)
► Just What You Need To Know About Variance Swaps, with E. Strasser, R. Guichard,
JPMorgan Equity Derivatives Report (2005)
55
55

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24 February 2007

Introduction to Volatility Trading and Variance Swaps

Volatility Trading and Variance Swaps

►Key concepts behind Black-Scholes............................................................. 5

►Black-Scholes in practice ............................................................................12

►Managing an option book ........................................................................... 21

►Trading volatility .......................................................................................... 27

►P&L path-dependency ................................................................................ 39

►Variance swaps ...........................................................................................45

Key concepts behind Black-Scholes

My Life as a Quant, John Wiley & Sons, 2004

Key concepts behind Black-Scholes

►Intuitive parameters: spot price, interest rate, volatility

►Arbitrage argument: dynamic hedging strategy

Key concepts behind Black-Scholes

Key concepts behind Black-Scholes

►False – Different agents have different uses for options:

►Bets: individual investors, asset managers

►Hedging: corporate investors

►Volatility trading: traders, hedge funds

Key concepts behind Black-Scholes

►False but in one case:

►False in practice: discrete hedging, jumps, stochastic volatility may have a

Key concepts behind Black-Scholes

►NOT a good model for the real behavior of stock prices

►BUT a powerful, simple toy model to:

►Interpret a market quote (more on this in the next section)

Maturity Black Scholes Option Price

Interest & Dividend

Maturity Black Scholes Option Price

Interest & Dividend

Source: Bloomberg. Data as of 18 October 2006.

►Implied Volatility Smile (or Skew)

►In Black-Scholes the volatility parameter is assumed to remain constant

►… in practice every option expiring at time T has a different implied volatility

►Implied Volatility Term Structure

+ term structure = 10%

ATM Implied volatility

►Stock prices do not follow the log-normal diffusion postulated by Black-

►Delta-hedging cannot take place continuously, transaction costs can be

►From a fundamental value perspective, implied volatility can be seen as a market

SPX Index linear regression

Managing an Option Book

►The job of an option market-maker is to provide liquidity to option buyers and

►Change in spot price: small & large

►Change in implied volatility

►Change in interest rate

Managing an Option Book

Managing an Option Book

►Book = Long 1,000 Option 1 and Short 500 Option 2

►Book Value = 1,000 x Price 1 – 500 x Price 2 (‘mark-to-market’)

►Book Delta = 1,000 x Delta 1 – 500 x Delta 2

Managing an Option Book

►Initial Book Delta = $5,000 per S&P 500 index point

►Delta-hedge = Sell 5,000 units of S&P 500

Managing an Option Book

►However, it is usually impossible to perfectly hedge all Greeks.

►This implies that the market-maker is left with some risks.

Taleb: ‘Volatility is best defined as the amount of variability in the returns of a

►False – The trading P&L on a delta-hedged option position is ‘path-dependent.’

►With Greek notations:

►What is σ? σRealised or σImplied?

►In this idealized world there is only one volatility: