Chapter 7

Option Greeks

1 © 2004 South-Western Publishing

 Outline
 Introduction
 The principal option pricing derivatives
 Other derivatives
 Delta neutrality
 Two markets: directional and speed
 Dynamic hedging

2
 Introduction
 Thereare several partial derivatives of the
BSOPM, each with respect to a different
variable:
– Delta
– Gamma
– Theta
– Etc.

3
 The Principal Option Pricing
Derivatives
 Delta
 Measure of option sensitivity
 Hedge ratio
 Likelihood of becoming in-the-money
 Theta
 Gamma
 Sign relationships

4
 Delta
 Delta
is an important by-product of the
Black-Scholes model

 There are three common uses of delta

 Deltais the change in option premium

expected from a small change in the stock
price

5
 Measure of Option Sensitivity
 For a call option:
∂C
∆c =
∂S
 For a put option:
∂P
∆p =
∂S

6
 Measure of Option Sensitivity
(cont’d)
 Delta
indicates the number of shares of
stock required to mimic the returns of the
option
– E.g., a call delta of 0.80 means it will act like 0.80
shares of stock
 Ifthe stock price rises by $1.00, the call option will
advance by about 80 cents

7
 Measure of Option Sensitivity
(cont’d)
 For a European option, the absolute values
of the put and call deltas will sum to one

 In the BSOPM, the call delta is exactly equal

to N(d1)

8
 Measure of Option Sensitivity
(cont’d)
 The delta of an at-the-money option
declines linearly over time and approaches
0.50 at expiration
 The delta of an out-of-the-money option
approaches zero as time passes
 The delta of an in-the-money option
approaches 1.0 as time passes

9
 Hedge Ratio
 Delta is the hedge ratio
– Assume a short option position has a delta of
0.25. If someone owns 100 shares of the stock,
writing four calls results in a theoretically
perfect hedge

10
 Likelihood of Becoming In-the-
Money
 Deltais a crude measure of the likelihood
that a particular option will be in the money
at option expiration
– E.g., a delta of 0.45 indicates approximately a
45 percent chance that the stock price will be
above the option striking price at expiration

11
 Theta
 Theta is a measure of the sensitivity of a
call option to the time remaining until
expiration:
∂C
Θc =
∂t

∂P
Θp =
∂t
12
 Theta (cont’d)
 Thetais greater than zero because more
time until expiration means more option
value

 Because time until expiration can only get

shorter, option traders usually think of theta
as a negative number

13
 Theta (cont’d)
 The passage of time hurts the option holder

 Thepassage of time benefits the option

writer

14
 Theta (cont’d)

Calculating Theta
For calls and puts, theta is:
−.5 ( d1 ) 2
Sσ e − rt
Θc = − − rKe N (d 2 )
2 2πt
−.5 ( d1 ) 2
Sσ e
Θp = + rKe − rt N (d 2 )
2 2πt
15
 Theta (cont’d)

Calculating Theta (cont’d)

The equations determine theta per year. A theta

of –5.58, for example, means the option will lose
$5.58 in value over the course of a year ($0.02 per
day).

16
 Gamma
 Gamma is the second derivative of the
option premium with respect to the stock
price
 Gamma is the first derivative of delta with
respect to the stock price
 Gamma is also called curvature

17
 Gamma (cont’d)

∂ 2C ∂∆ c
Γc = 2 =
∂S ∂S

∂ 2 P ∂∆ p
Γp = 2 =
∂S ∂S

18
 Gamma (cont’d)
 As calls become further in-the-money, they
act increasingly like the stock itself
 For out-of-the-money options, option prices
are much less sensitive to changes in the
underlying stock

 An option’s delta changes as the stock

price changes

19
 Gamma (cont’d)
 Gamma is a measure of how often option
portfolios need to be adjusted as stock
prices change and time passes
– Options with gammas near zero have deltas
that are not particularly sensitive to changes
in the stock price
 Fora given striking price and expiration,
the call gamma equals the put gamma
20
 Gamma (cont’d)

Calculating Gamma
For calls and puts, gamma is:

−.5 ( d1 ) 2
e
Γc = Γp =
Sσ 2πt

21
 Sign Relationships

  Delta Theta Gamma

Long call + - +
Long put - - +
Short call - + -
Short put + + -

The sign of gamma is always opposite to the sign of theta
22
 Other Derivatives
 Vega
 Rho
 The greeks of vega
 Position derivatives
 Caveats about position derivatives

23
 Vega
 Vegais the first partial derivative of the
OPM with respect to the volatility of the
underlying asset:
∂C
vega c =
∂σ

∂P
vega c =
∂σ
24
 Vega (cont’d)
 All long options have positive vegas
– The higher the volatility, the higher the value of the option
– E.g., an option with a vega of 0.30 will gain 0.30% in value
for each percentage point increase in the anticipated
volatility of the underlying asset

 Vega is also called kappa, omega, tau, zeta, and

sigma prime

25
 Vega (cont’d)

Calculating Vega

−0.5 ( d12 )
S te
vega =
2π

26
 Rho
 Rho is the first partial derivative of the OPM
with respect to the riskfree interest rate:

ρ c = Kte N (d 2 )
− rt

ρ p = − Kte − rt N (−d 2 )

27
 Rho (cont’d)
 Rho is the least important of the derivatives
– Unless an option has an exceptionally long life,
changes in interest rates affect the premium
only modestly

28
 The Greeks of Vega
 Twoderivatives measure how vega
changes:
– Vomma measures how sensitive vega is to
changes in implied volatility
– Vanna measures how sensitive vega is to
changes in the price of the underlying asset

29
 Position Derivatives
 The position delta is the sum of the deltas
for a particular security
– Position gamma
– Position theta

30
 Caveats About Position
Derivatives
 Position derivatives change continuously
– E.g., a bullish portfolio can suddenly become
bearish if stock prices change sufficiently
– The need to monitor position derivatives is
especially important when many different option
positions are in the same portfolio

31
 Delta Neutrality
 Introduction
 Calculatingdelta hedge ratios
 Why delta neutrality matters

32
 Introduction
 Deltaneutrality means the combined deltas
of the options involved in a strategy net out
to zero
– Important to institutional traders who establish
large positions using straddles, strangles, and
ratio spreads

33
 Calculating Delta Hedge Ratios
(cont’d)

A Strangle Example

A stock currently trades at $44. The annual volatility of the

stock is estimated to be 15%. T-bills yield 6%.

An options trader decides to write six-month strangles using

$40 puts and $50 calls. The two options will have different
deltas, so the trader will not write an equal number of puts
and calls.

How many puts and calls should the trader use?

34
 Calculating Delta Hedge Ratios
(cont’d)

A Strangle Example (cont’d)

Delta for a call is N(d1):

 44   .152 
ln  +  .06 + .5
 50   2 
d1 = = −.87
.15 .5
N (−.87) = .19
35
 Calculating Delta Hedge Ratios
(cont’d)

A Strangle Example (cont’d)

For a put, delta is N(d1) – 1.

 44   .152 
ln  +  .06 + .5
 40   2 
d1 = = −1.23
.15 .5
N (−1.23) − 1 = −.11
36
 Calculating Delta Hedge Ratios
(cont’d)

A Strangle Example (cont’d)

The ratio of the two deltas is -.11/.19 = -.58.

This means that delta neutrality is achieved
by writing .58 calls for each put.

One approximate delta neutral combination

is to write 26 puts and 15 calls.
37
 Why Delta Neutrality Matters
 Strategiescalling for delta neutrality are
strategies in which you are neutral about
the future prospects for the market
– You do not want to have either a bullish or
a bearish position

38
 Why Delta Neutrality Matters
(cont’d)
 Thesophisticated option trader will revise
option positions continually if it is
necessary to maintain a delta neutral
position
– A gamma near zero means that the option
position is robust to changes in market factors

39
 Two Markets: Directional and
Speed
 Directional
market
 Speed market
 Combining directional and speed markets

40
 Directional Market
 Whether we are bullish or bearish indicates
a directional market

 Delta
measures exposure in a directional
market
– Bullish investors want a positive position delta
– Bearish speculators want a negative position
delta

41
 Speed Market
 Thespeed market refers to how quickly we
expect the anticipated market move to
occur
– Not a concern to the stock investor but to the
option speculator

42
 Speed Market (cont’d)
 In fast markets you want positive gammas

 In slow markets you want negative gammas

43
 Combining Directional and
Speed Markets
Directional Market

Down Neutral Up

Slow Write calls Write Write puts

straddles
Speed Neutral Write calls; Spreads Buy calls;
Market buy puts write puts

Fast Buy puts Buy Buy calls

straddles
44
 Dynamic Hedging
 Introduction
 Minimizing the cost of data adjustments
 Position risk

45
 Introduction
A position delta will change as
– Interest rates change
– Stock prices change
– Volatility expectations change
– Portfolio components change

 Portfolios need periodic tune-ups

46
 Minimizing the Cost of Data
Adjustments
 Itis common practice to adjust a portfolio’s
delta by using both puts and calls to
minimize the cash requirements associated
with the adjustment

47
 Position Risk
 Position risk is an important, but often
overlooked, aspect of the riskiness of
portfolio management with options

 Option derivatives are not particularly

useful for major movements in the price
of the underlying asset

48
 Position Risk (cont’d)

Position Risk Example

Assume an options speculator holds an aggregate portfolio

with a position delta of –155. The portfolio is slightly bearish.

Depending on the exact portfolio composition, position risk

in this case means that the speculator does not want the
market to move drastically in either direction, since delta is
only a first derivative.

49
 Position Risk (cont’d)

Position Risk Example (cont’d)

Profit

Stock Price

50
 Position Risk (cont’d)

Position Risk Example (cont’d)

Because of the negative position delta, the curve moves into

profitable territory if the stock price declines. If the stock
price declines too far, however, the curve will turn down,
indicating that large losses are possible.

On the upside, losses occur if the stock price advances a

modest amount, but if it really turns up then the position
delta turns positive and profits accrue to the position.
51