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Getting to Know the Greeks

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current market price or a put option whose


strike price is above the current market price) is
referred to as being in-the-money (ITM). An
option that is not sitting in a payoff position
(i.e., a call option whose strike price is above
the current market price or a put option whose
strike price is below the current market price) is
said to be out-of-the-money (OTM). The further
ITM (or the less OTM), the more the option will
be worth, as the probability of a payoff is
greater. The more volatile its underlying
market, the more an option will be worth, again
because there is a greater probability that it will
move into a payoff position. Finally, the more
In this article we explain some of the key time to expiration, the more an option will be
elements of option pricing and illustrate worth as the more time it has to move into a
how an option pricing model can be used payoff position.
to design and monitor an options-based
trading or hedging strategy. We also The price or value of an option consists of both
introduce the concept of an options intrinsic and extrinsic value. Intrinsic value is
book, which is a way of netting the the amount the option is ITM (if any). An option
various risks associated with a multi- will normally be worth at least as much as its
option position. Our focus is on the intrinsic value (otherwise an arbitrage
concepts rather than the mathematics of opportunity presents itself). A June crude oil
option pricing. call with a strike price of $100/bbl and an
underlying June futures price of $105/bbl has
The value of a typical commodity option is intrinsic value of $5/bbl. If this call option
driven by four key factors: the strike price, the happens to be trading at $9/bbl, then it has an
current market price of the underlying intrinsic value of $5/bbl and an extrinsic value
commodity, volatility and the time to expiration. of $4/bbl. Calculating the intrinsic value of an
An option whose strike price is equal to the option is straightforward. Thus the option
current market price of the underlying pricing problem is really all about placing a value
commodity is said to be at-the-money (ATM). on the extrinsic value or time premium as it is
An option that is sitting in a payoff position (i.e., sometimes called.
a call option whose strike price is below the

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Getting to Know the Greeks

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Using an Options Pricing Model vega. Delta and gamma relate to how the value
of the option changes as it moves in and out of
For exchange-traded options, pricing models the money, as determined by changes in the
such as our proprietary PositionBook software price of the underlying commodity. Theta
are used for two main purposes: (1) by option concerns itself with measuring the impact of
market-makers to determine the prices they are time on the value of the option. Vega is our
willing to buy and sell options; and (2) by option measure of the impact of changes in volatility.
traders to measure the risks involved in various Each of these measures calculates the impact
types of option-based strategies. In this article on option value holding everything else constant
we will concern ourselves only with the latter. (i.e., ceteris paribus).

For an exchange-traded option, we dont need Vega


to use a pricing model to determine the value of
the option because the market tells us its value. Vega measures the impact of changes in
Rather, we use an option pricing model to better volatility on the value of an option. Vega tells
understand the risks and potential payoffs of a us how much the value of the option will change
position in relation to changes in the underlying given a one percentage point change in implied
price, volatility and time. For example, how volatility (i.e., going from 24% to 25%). Rather
much will it cost us in time value to hold a long than thinking of this in terms of a single unit
options position as part of a hedging strategy? (e.g., bushel, tonne, barrel, etc.), we find it
How much of a payoff can we expect from a much more intuitive to think of it in terms of a
long put position if prices drop by 20% over the position. We like to call this the position Greek
next six months? How much value will be left in as opposed to the raw Greek. For example, if
those options six months from now if prices stay we have a long option position with a vega of
flat? How much risk are we taking on a short $15,650, then a one percentage point increase
option position if volatility increases significantly in implied volatility will increase the value of this
prior to expiration? These are the types of position by about $15,650. Conversely, a one
questions we can answer with a good pricing percentage point decrease in implied volatility
model. will decrease the value of this position by about
$15,650. For a short option position our
The Greeks exposure to volatility would be the opposite.
Vega helps us understand how sensitive a
The risk measures associated with option position is to changes in implied volatility.
pricing are affectionately known as the Greeks
and the main ones are delta, gamma, theta and

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Getting to Know the Greeks

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Theta An example of delta is a long position of 100


ATM crude oil call options, with a raw delta of
Theta is perhaps the easiest Greek to 0.5. The notional size of this position is 100,000
understand, as it simply measures the rate at barrels, but the delta-equivalent is only 50,000
which time decay is occurring in an option. All barrels, because for every $1/bbl change in the
else being equal, options decrease in value as futures price, the value of the option only
time passes. If we are long the option, then changes by about $0.50/bbl, or at half the rate
time decay is working against us. If we are of the futures. So in essence, the delta-
short the option, then time decay is working in equivalent of the position is the same as the
our favor. If we are short some options with a futures-equivalent of the options.
position theta of $1,200, we are earning about
$1,200 per day in time decay. Theta is valid for Gamma
a short period of time since it changes also with
the passage of time. If we were long these Gamma is the other Greek that helps us
same options, we would be incurring time decay understand how the value of our option will
of about $1,200 per day, or in other words we change given a change in the value of the
would be losing about $1,200 per day due to underlying commodity. Gamma tells us how
time decay. fast our delta changes as the underlying futures
price changes. Our long crude oil call position
Delta from above has a delta of 50,000 barrels, but
might have a gamma of say 3,100 barrels. This
Delta is the king of the Greeks and the one you means that our position delta increases by
really need to master if you are going to trade 3,100 barrels given a one dollar increase in the
options. Delta helps us understand how the underlying futures, making us 3,100 barrels
value of the option changes given a change in longer, on a delta-equivalent or futures-
the price of the underlying commodity. equivalent basis (i.e. delta would increase from
Depending on how far in or out of the money 50,000 to 53,100). For basic option trades and
our option is, the delta can vary from zero for a hedges, gamma doesnt really help us that much
deep OTM option, to 1.0 for a deep ITM option. and we can likely learn more about the
An option with a delta of 1.0 is acting just like dynamics of the option position and its delta
the underlying futures, since its value is through sensitivity analysis. However, for
changing one-for-one along with the underlying certain types of option strategies, such as delta-
futures price. neutral trading, understanding your gamma risk
is critical. Gamma is critical to appreciate in
situations where prices are jumping or

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Getting to Know the Greeks

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gapping, as a delta-neutral strategy fails to The following hypothetical crude oil example is
properly replicate a long option position. based on calculations performed by our
proprietary PositionBook software. In this
The Options Book Concept position we are short calls and long puts, the
type of collar that energy producers commonly
While you can get a pretty good intuitive feel of use. The notional size of this position is 740,000
the pricing dynamics of a simple option position, bbl (740 contracts), but our combined delta-
this quickly evaporates when you start getting a equivalent is only short 59,693 bbl, or about 60
few different options on the books. This is why, contracts. Note that both the short calls and
after more than twenty five years of dealing long puts have a negative delta, as they are
with options, I believe that nothing brings the both essentially short positions (i.e., they
Greeks to life better than the concept of an benefit if the price goes down and lose if the
options book. An options book involves price goes up). The important thing to
combining all of your positions and expressing understand is that the delta-equivalent is a
the Greeks in terms of their position- better indicator of the size of your position than
equivalents. The nice thing about this is that the notional.
the position-equivalent Greeks are additive,
thus allowing you to calculate your net Note that our short calls have a combined
combined position. positive theta of $575/day. Since we are short
these calls, we are earning time value of

Illustration of an Options Book for Crude Oil (CL)


Position Equivalent Greeks
Long or # of Strike Call or Days to Futures Price Notional Gamma Theta Vega
Short Contracts ($/bbl) Month Put Expiry ($/bbl) (bbl) Delta (bbl) (bbl) ($/day) ($/point)

Short 100 $ 120 Jun Call 128 $ 93.11 - 100,000 - 2,018 - 474 $ 212 -$ 2,987
Short 120 $ 130 Aug Call 191 $ 91.78 - 120,000 - 1,556 - 310 $ 144 -$ 3,004
Short 150 $ 130 Dec Call 314 $ 89.25 - 150,000 - 3,630 - 551 $ 219 -$ 7,812
Long 100 $ 80 Jun Put 128 $ 93.11 - 100,000 - 12,660 1,492 -$ 1,067 $ 11,691
Long 120 $ 75 Aug Put 191 $ 91.78 - 120,000 - 13,633 1,324 -$ 999 $ 15,650
Long 150 $ 75 Dec Put 314 $ 89.25 - 150,000 - 26,196 1,968 -$ 1,144 $ 32,219
Total 740 - 740,000 - 59,693 3,449 -$ 2,635 $ 45,757

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Getting to Know the Greeks

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$575/day. Our long puts have a combined negative One very important point to remember is
theta of $3,210/day, meaning that we are incurring that the option Greeks are dynamic in nature,
time decay of this amount on these puts. Since we meaning that their values change as time
are both long puts and short calls in our overall passes, volatility changes and the underlying
position, the positive theta on the short calls offsets futures price moves up and down. So while
the negative theta on the long puts, so our the Greeks are great analytical tools, they are
combined theta is -$2,635/day. So overall, we are no replacement for sensitivity analysis and
incurring time decay of about $2,635/day for stress testing of your position. v
holding this position.

Our short calls have a combined negative vega of


-$13,803. So for a one percentage point increase
in implied volatility, we would lose about $13,803,
since they would go up in value by this amount
(and vice versa if implied volatility drops by one
percentage point). Our long puts have a combined
positive vega of $59,560, which means they will
increase in value by this amount given a one
percentage point increase in implied volatility. On
our overall position, we have a combined positive
vega of $45,757, which for most traders would be
considered a large volatility position.

The above example illustrates how we can combine


various options together into one book. We could
also add any futures positions to this book, which
would allow us to net our entire futures and options
position together. Short futures positions have a
delta of -1.0 and long futures positions have a delta
of +1.0. Gamma, theta and vega dont apply to
futures, since the delta remains fixed at -1.0 or
+1.0, and there is no time decay or implied Note: A trial version of PositionBook
volatility associated with a futures position. can be downloaded from:
PositionBook also prices more exotic options such www.positionbook.com
as average-rate and barrier options.

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Copyright 2014 Gibson Capital Inc. All Rights Reserved.