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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

research@gibsoncapital.ca www.gibsoncapital.ca

Getting to Know the Greeks

Page 2

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).

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

research@gibsoncapital.ca www.gibsoncapital.ca

Getting to Know the Greeks

Page 3

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

research@gibsoncapital.ca www.gibsoncapital.ca

Getting to Know the Greeks

Page 4

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

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

research@gibsoncapital.ca www.gibsoncapital.ca

Getting to Know the Greeks

Page 5

$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.

-$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.

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.

research@gibsoncapital.ca www.gibsoncapital.ca

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