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BuRSA ColuMN

Understanding Options Greeks

Options Greeks
In this Options series, we will identify the level of sensitivity in the relationship of variable factors to Options price known as Options Greeks.
By Phillip Futures
ast month, we introduced the concept of options pricing. Other than knowing the directional relationship between these variable factors and options price, we should also take into consideration the sensitivity of these relationships, which is measured by the Options Greeks. Delta: This is the most commonly used Greek; it is the ﬁrst-order sensitivity between the option price and the underlying asset price. In simpler terms, Delta (∆) measures how much an investor stands to gain or lose if the price of the underlying moves a little.

Understanding

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money (ATM), delta is close to 0.5 sen for a call option and close to -0.5 sen for a put option. Derivatives traders and dealers often use “delta hedging” to reduce their risk associated with price movements in the underlying. This is done by calculating the delta of a portfolio with respect to the underlying and offsetting it with an opposing portfolio of ﬁnancial assets with the same delta with respect to the same underlying. The

objective is to minimise or eliminate any change to the value of the portfolio due to small movements in underlying asset price. A simple illustration shows how the risks of a call option can be hedged with its underlying. Assume you hold 1,000 Oct2012 OCPO call options with delta = 0.40, the risks of option premium change as a result of price movements in FCPO can be offset by shorting 400 underlying Oct2012 FCPO.

Delta is a number between -1 and 1; when delta is 0.5, it means when the underlying price increases by RM1.00, the option price will increase by 0.5 sen. Call options have positive deltas and put options have negative deltas because of their respective positive and negative relationships between underlying price and option price, as discussed above. When at-the-

Chart 2: Call and Put Delta against Underlying Asset Price Source: Phillip Futures

October 2012

as the option becomes increasingly more ITM or OTM.924 400 x (2.5 = 53.600) (1.500 – 55.600) 2.01pm P&L at 4.000 55.000 x 55. Higher Probability of Options becoming ITM Source: Phillip Futures Gamma: This is the second-order relationship between option price and underlying asset price.000 x 53.500 53. It is the sensitivity of the option price to time.5 1. gamma is usually highest when the option is ATM and lowest when the option is deep ITM or OTM. Vega: Vega measures the sensitivity of the option price to the (implied) volatility of the underlying asset price.919) = (1.5 = 55. The Vega curve is also similar to that of a normal distribution curve.167. The proﬁle for both (long) call and put options are similar.13pm ∆P&L Short 400 2.13pm P&L at 5. Theta: Theta affects only the time value of money (TVM) portion of an option’s premium. it measures how sensitive the delta is to changes in the underlying asset price.600) – (1.500 53. Again the underlying logic is simple: when ATM.000 Chart 1: Higher Volatility. where sensitivity of option price to implied volatility is the highest when the option is ATM. even a small change in the underlying asset price may affect the moneyness of (hence risk associated with) the option. the change required in the underlying asset price to affect the moneyness of the option increases.500 = -2.01pm Price at 5.5 1.169. A large gamma means the delta changes rapidly with a small change in the underlying asset price. As shown in the diagram above.40 Long 1.000 BMD Oct2012 OCPO 2950 C on 27-Jul-2012 0.924) = (1.919 400 x (2. Chart 3: Gamma against Underlying Asset Price Source: Phillip Futures October 2012 . as such a smaller gamma is generally more favourable to investors using delta-hedging for their portfolios.014 BuRSA ColuMN Understanding Options Pricing BMD Oct2012 FCPO On 27-Jul-2012 Delta Investment Price at 4.167.169.600) = 2. and measure how much an option loses premium per day purely due to the passage of time.