Options

Guanglian Hu

S1, 2020

Guanglian Hu S1 2020 S1 2020 1 / 19

The Black-Scholes-Merton Model (BSM): physical
dynamics

The BSM model assumes the following dynamics of the underlying

asset under the physical measure (P):

dSt
= µdt + σdBt
St
where St is the price of the underlying asset at time t, σ is the
volatility parameter, and µ is the drift or the expected return of the
underlying asset.
Future stock price ST is given by
1 2 τ + σ √τ Z
ST = St e µτ − 2 σ

where τ = T − t and Z is a standard normal shock. Also note

E P (ST ) = St e µτ
Guanglian Hu S1 2020 S1 2020 2 / 19
The BSM Model: risk neutral dynamics

The dynamics under the risk neutral measure (Q):

dSt
= rdt + σdBt
St
where St is the price of underlying asset at time t, σ is the volatility
parameter, and r is the risk-free rate.
Note under Q, the stock price is appreciating at a lower rate (µ > r ).
Future stock price ST under the risk-neutral measure is given by
1 2 τ + σ √τ Z
ST = St e r τ − 2 σ

where τ = T − t and Z is a standard normal shock. Also note

E Q (ST ) = St e r τ

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The BSM Model: future stock price distribution
Based on St = 100, µ = 10%, σ = 25%, r = 0.03, τ = 1 year

0.025
Physical
Risk neutral

0.02

0.015

0.01

0.005

0
0 50 100 150 200 250 300
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The BSM Model: pricing formulae

The Black-Scholes-Merton option pricing formulae:

Ct (τ , St , σ, K , r ) = St N (d1 ) − e −r τ KN (d2 )
Pt (τ , St , σ, K , r ) = e −r τ KN (−d2 ) − St N (−d1 )

ln SKt + (r + 21 σ 2 )τ ln SKt + (r − 21 σ 2 )τ
d1 = √ d2 = √ .
σ τ σ τ
N is the cumulative probability function of a standard normal variable
Option price is a function of τ , St , σ, K , r . Note that µ drops out.
Volatility σ is the only unobservable quantity. There is a one-to-one
correspondence between option price and volatility. In practice, option
prices are often quoted with volatility.
Given option price, one can invert the above pricing formulae to
obtain an estimate of volatility, the so-called implied volatility.

Guanglian Hu S1 2020 S1 2020 5 / 19

Option Greeks

Option Greeks are the partial derivatives of option price with respect
to the model parameters
Examples: delta, gamma, vega, theta
Usually traders use the BSM model when calculating partial
derivatives.
BSM Greeks + adjustments

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Option Greeks: Delta

Delta (∆ = ∂O∂S ) is the rate of change of option price with respect to

the underlying asset price
∆c = ∂C
∂S = N (d1 ) and ∆p = ∂S = N (d1 ) − 1
∂P

∆ is positive for calls and negative for puts.

Again, keep in mind call option has positive beta while a put option has negative beta
What is the delta of the underlying stock?

Delta-neutral portfolios

Guanglian Hu S1 2020 S1 2020 7 / 19

The BSM Model: delta of a call option

Call Delta Against Stock Price

1

0.9

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0
0 10 20 30 40 50 60 70 80 90 100

Based on K = 50, σ = 25%, r = 0.0, τ = 2 year

ITM calls have delta close to 1 and OTM calls have delta close to 0.

Guanglian Hu S1 2020 S1 2020 8 / 19

The BSM Model: delta of a put option

Put Delta Against Strike Price

0

-0.1

-0.2

-0.3

-0.4

-0.5

-0.6

-0.7

-0.8

-0.9

-1
0 10 20 30 40 50 60 70 80 90 100

Based on K = 50, σ = 25%, r = 0.0, τ = 2 year

∆ becomes larger in magnitude as options move towards the in-the-money
direction.

Guanglian Hu S1 2020 S1 2020 9 / 19

Option Greeks: Vega

Vega (ν = ∂O
∂σ ) is the rate of change of option price with respect to
volatility
∂C ∂P √
∂σ = ∂σ = S τ φ(d1 ), φ is the probability density function of a
standard normal variable

Vega is the same for both call and put options and is always positive
Intuition: a high volatility stock has a greater price potential

Guanglian Hu S1 2020 S1 2020 10 / 19

Option Greeks: variation of vega
30
3-month
1 year
2 year
25

20

15

10

0
0 50 100 150

Based on K = 50, σ = 25%, r = 0.0

ATM options have larger vega.
Intuition: at-the-money options are more sensitive to changes in volatility
Also the more time remaining to option expiration, the higher the vega.
Guanglian Hu S1 2020 S1 2020 11 / 19
Option Greeks: Gamma

2
Gamma (Γ = ∂∂SO2 ) is the rate of change of delta with respect to the
underlying stock price. It is the second partial derivative of option
price with respect to the underlying stock price
∂∆c ∂∆p φ ( d1 )
∂S = ∂S = S τ σ
√
Intuitively gamma measures how option prices respond to a potential jump in stock price
(either upward or downward)

Gamma is the same for both call and put options and is always
positive.

Guanglian Hu S1 2020 S1 2020 12 / 19

Option Greeks: Gamma
0.07
3-month
1 year
2 year
0.06

0.05

0.04

0.03

0.02

0.01

0
0 50 100 150

Based on K = 50, σ = 25%, r = 0.0

ATM options have larger gamma as compared to ITM and OTM options
As the time-to-maturity draws nearer, the gamma of ATM options increases while
gamma of ITM and OTM options decreases.
Guanglian Hu S1 2020 S1 2020 13 / 19
Option Greeks: Theta

∂O
Theta (Θ = ∂t ) is the rate of change of option price with respect to
the time.

In general, theta is negative for an option. As options get closer to

maturity, time value of the option is decreasing. This is also called
time-decay.

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 Empirical Performance of the BSM model

The BSM model provides a useful benchmark, but it has many

shortcomings. The primary drawback is that the model assumes a
constant volatility

Time varying stock market volatility is now well documented

Volatility smirk/smile in the option data is also inconsistent with the

constant volatility assumption

Negative average returns on OTM index options are inconsistent with

the BSM model

Guanglian Hu S1 2020 S1 2020 15 / 19

Time-series of realized volatility of the S&P 500

500

450

400

350

300

250

200

150

100

50

0
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Note: monthly volatility is computed using 5-min returns within the month.

Guanglian Hu S1 2020 S1 2020 16 / 19

Volatility Smirk/smile

In practice we observe market prices of options so we can invert the

BSM model to back out the volatility parameter from observed option
prices (this is called option implied volatility).
if you recall, volatility is the only unknown quantity in BSM model
Implied volatility surface: option implied volatilities along both the
moneyness and maturity dimensions.
According to the BSM model, option implied volatilities should be the
same across moneyness and maturity
The implied volatility surface should be flat.
However, implied volatilities from OTM options are consistently
higher than implied volatilities from ATM options. This pattern is
often referred to as the volatility smirk/smile.
Prior to 1987 market crash, the implied volatility surface is flat.

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Comparing average call option returns with those implied
by the BSM model
Average monthly returns of S&P 500 calls, sample period: 1998 to 2015

0.2

0.15

0.1

0.05

0
Expected Return

-0.05

-0.1

-0.15

-0.2

-0.25
Data
BSM
-0.3
96 98 100 102 104 106 108
K
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Comparing average put option returns with those implied
by the BSM model
Average monthly returns of S&P 500 puts, sample period: 1998 to 2015
-0.05

-0.1

-0.15

-0.2

-0.25
Expected Return

-0.3

-0.35

-0.4

-0.45

-0.5 Data
BSM

-0.55
92 94 96 98 100 102 104
K
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