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Copyright © 2000-2006

Investment Analytics

1

Agenda

Option sensitivity factors

Delta

Delta hedging

Option time value

Gamma and leverage

Volatility sensitivity

Gamma and Vega hedging

Option Sensitivity Factor

What affects the price of an option

the asset price, S

the volatility, σ

the interest rate, r

the time to maturity, t

the strike price, X

Option Greeks

Delta (“price sensitivity”)

change in option price due to change in stock price

Gamma (“leverage”)

change in delta due to change in stock price

Vega (“volatility sensitivity”)

change in option price due to change in volatility

Theta (“time decay”)

change in option value due to change in time to

maturity

Copyright © 2000-2006 Investment Analytics Option Risk Management Slide: 4

Option Delta

Key sensitivity

Change in option value for $1 change in

underlying stock

Range –1 to +1

Option Delta

Put options: negative delta

Call options: positive delta

Delta Example

Delta tells us how the call price changes

If stock moves up by $10, call price increases by $5

If stock drops by $10, call price decreases by $5

Delta Position

Delta Position

The call ‘behaves’ like 0.5 units of stock

If we hold 10 calls, our position behaves

like 5 units of stock

we say we are “long 5 deltas”

Position Deltas

Call options

have positive delta

like being long stock

Put options

have negative delta

like being short stock

Stock - has a delta of 1!

Bonds - have a delta of zero

Combinations

may have positive, negative or zero delta

Delta Hedging

Example, 10 calls, each of delta 0.5

How to hedge: Sell Delta units of stock

This creates a portfolio of 10 calls plus -5 units of stock

The combined position has a delta of +5 - 5 = 0

Like being long 5 stock & short 5 stock = net zero stock

The value of the portfolio will be unchanged, no matter whether the

stock moves up or down

Delta Neutral Positions

A portfolio is hedged when its position delta is zero

We say we have a delta-neutral position

Examples: assume call delta 0.5, put delta -0.5

Long 10 calls, short 5 stock

Long 10 calls, long 10 puts

Short 10 calls, long 5 stock

Short 10 puts, short 5 stock

Short 10 puts, short 8 calls, short 1 stock

Delta Neutral Strategies

Delta neutral strategies are non-directional

Often make money while market doesn’t move

Examples:

Butterflies, straddles, strangles are typically delta neutral

Directional strategies are typically not delta-

neutral

Call spreads have +ve delta

Put spreads have -ve delta

The Delta of a Call Option

Delta changes as stock price changes

Gamma measures rate of change of delta

In the

money

Out of the At the

Call Value

money money 1

0 0.5

X Stock Price

Copyright © 2000-2006 Investment Analytics Option Risk Management Slide: 12

IBM Option Delta

A New Look at Delta

Delta =

Probability of

Probability

Option

Finishing in-

the-money

S X.e-rt

Out-of-the-Money

Copyright © 2000-2006 Investment Analytics Option Risk Management Slide: 14

Delta: At-the-Money

Probability

S = X.e-rt

At-the-Money

Copyright © 2000-2006 Investment Analytics Option Risk Management Slide: 15

Delta: In-The-Money

Delta 1

Probability

X.e-rt S

In-the-Money

Copyright © 2000-2006 Investment Analytics Option Risk Management Slide: 16

Delta: Conclusions

Delta “measures probability of finishing in the

money”

A deep out-of-the money option has a low delta

An at-the-money has a delta of around 0.5 as it

approaches expiry

i.e. a 50-50 chance of ending up in the money

As an option moves deep into the money, its

delta rapidly approaches 1

Gamma measures rate of change of Delta

Option Value

Intrinsic Value • Asset Price

• Strike Price

• Interest rates

Expiration

• Volatility

How Time Value Decays

9 months

6months

3 months

Premium

Expiration

Stock price

Strike Price

Copyright © 2000-2006 Investment Analytics Option Risk Management Slide: 19

Time Decay (Theta)

Decay Acceleration

Premium

0

Copyright © 2000-2006 Investment Analytics Option Risk Management Slide: 20

Time Value of IBM Option

IBM Option Theta

Option Gamma

Measures change of Delta for $1 change in stock

“Rate of Acceleration” of option value with stock

price

Call and put options have positive gamma

Option delta becomes larger as stock appreciates

Becomes smaller (more negative) as stock declines

Gamma changes as underlying stock moves

Highest for ATM options

IBM Option Gamma

Lab: Leverage

An Experiment:

Assume stock $100

Risk free rate 10%, volatility 25%

Call option, strike price 100 (at the money)

Leverage:

If stock moves by $5, how much does

option value change?

Solution: Leverage

Call Prices Return

Maturity S=100 S=105 (%) Gamma

1.00 12.34 15.66 27% 0.015

0.50 8.26 11.48 39% 0.022

0.25 5.60 8.80 57% 0.032

0.10 3.40 6.69 97% 0.050

0.01 1.02 5.07 396% 0.160

NOTES:

Col 2 is option value with stock price = 100

Col 3 is option value with stock price = 105

Col 4 is ‘Leverage’: (C1 - C2)/C1

Time vs Leverage

Conclusions:

Time Value & Leverage

Gamma is a measure of leverage

An option with higher gamma gives “more bang for

the buck”

Gamma measures how option value “accelerates”

Gamma /Leverage increase as time to expiry falls

Gamma and Theta are “opposites”:

High leverage means rapid time decay

Volatility Greeks

Gamma - sensitivity to actual volatility

Example: Weather

People carrying umbrellas (implied risk of rain) = Vega

Rain (the wet stuff) = Gamma

Implied volatility

estimated s.d. implied by option prices by B-S model

“market’s” estimate of current volatility

Vega

Measures change in option value for 1%

change in implied volatility

Call and put options have positive Vega

Increase in value as implied volatility increases

Option positions may have positive or negative

Vega

Vega changes with underlying stock

Highest for ATM options

Most sensitive to changes in implied volatility

Copyright © 2000-2006 Investment Analytics Option Risk Management Slide: 30

IBM Option Vega

Lab: Option Sensitivities

Examine Delta, Gamma, Vega & Theta

Characteristic functions

How do they vary over time?

How do they vary with volatility?

Solution: Option Sensitivities

Delta Gamma

Vega Theta

Solution: Option Sensitivities

Delta

Short-dated, ATM options on less volatile

stock are more sensitive

Gamma

Greatest for short-dated ATM options on

less volatile stock

Solution: Option Sensitivities

Vega

Long-dated, ATM options on less volatile

stock more volatility sensitive

Theta

Short-dated ATM options on more volatile

stock experience greatest rate of decay

Volatility Types

Historical

Implied

Forecast

Seasonal

Historical Volatility

tested:

A: Volatility between consecutive trading days

B: Volatility over weekend (close Friday to close Monday)

Expected B = 3 x A

Found B was only 20% higher

Volatility is much higher on trading days

Use daily data from trading days (252 per year)

Estimating Historical Volatility

Standard Deviation

X i = Ln( Pi +1 / Pi )

σ= ∑ ( X i − X ) 2 / ( N − 1)

1

σ=

2N Ln(2)

∑Ln(Hi / Li )

Gamma Hedging

Suppose unhedged position = one call

You can make it delta neutral

But this only works for small changes

Need to eliminate gamma risk too

How do you make it Delta & Gamma neutral?

Can’t use stock: gamma is zero

Must use other options, O1 and O2

Solve:

mδ1 + nδ2 = 0

mΓ1 + nΓ2 = 0

Vega Hedging

Make a portfolio Delta-Vega neutral

Again, use other options

Solve:

mδ1 + nδ2 = 0

mV1 + nV2 = 0

Lab: Greek Hedging

Excel: Workbook

Worksheet: Greek hedging

Sensitivity:

Check how position value, delta changes with stock price

Check how position value changes with volatility

Hedging:

Gamma hedge the given portfolio

Check sensitivity of position to stock price

Use Solver

Greek Hedging –

Using SOLVER

Solution: Greek Hedging

Position Stock 45

Value Delta Gamma Vega Theta Volatility 14.0%

Portfolio -493.9 9.2 -15.9 -1,169.8 282.2 Risk Free 5.0%

Hedge 493.9 -9.2 15.9 1,168.1 -281.6

Net Position -0.0 -0.1 -0.0 -1.7 0.6

Target 0.0 0.0 0.0 1,169.8 282.2

Abs. Position 0.0 0.1 0.0 1.7 0.6

0.0 C 35 0.25 10.44 1.00 0.000 0.01 -1.73

0.0 C 40 0.25 5.53 0.97 0.020 1.49 -2.33

99.5 C 45 0.25 1.55 0.59 0.119 8.77 -3.70

2.0 C 50 0.25 0.14 0.10 0.053 3.90 -1.31

0.1 C 55 0.25 0.00 0.00 0.004 0.27 -0.08

0.0 P 35 0.25 0.00 0.00 0.000 0.01 0.00

-0.1 P 40 0.25 0.04 -0.03 0.020 1.49 -0.35

-0.7 P 45 0.25 0.99 -0.42 0.119 8.77 -1.47

75.3 P 50 0.25 4.52 -0.90 0.053 3.90 1.16

0.0 P 55 0.25 9.32 -1.00 0.004 0.27 2.63

Summary:

Option Risk Management

Option Greeks

Measures of option sensitivity

Delta hedging

Gamma & Vega hedging

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