Professional Documents
Culture Documents
The Greeks
Teaching Agenda
✓ Comparison of Stock, Futures and Options
✓ Difference between Futures and Option Hedge
✓ Option Risk Parameters
✓ Option Risk Parameter – Delta
◼ Delta Hedge & Limitation
◼ Example – Delta Hedge
✓ Option Risk Parameter – Gamma
◼ Example – Gamma Hedge
✓ Option Risk Parameter – Vega
✓ Option Risk Parameter – Theta
✓ Option Risk Parameter – Rho
✓ Attribution Analysis of Option Price Change
Recommended Reference:
Mastering Financial Calculations, Chapter – Options :
The Greek Letters
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Comparison of Stock, Futures and Options
Assumed the following market data: Assumed the following market data:
Current Stock Price = $105 Current Stock Price = $105
Call Option Strike = $100, Call Option Premium = $15 Put Option Strike = $100, Put Option Premium = $6
(Ignore the transaction cost) (Ignore the transaction cost)
◼ Long stock is expecting the stock price will go up in the future ◼ Short Stock is expecting the stock price will go down in the future
◼ Long Stock and Long Futures show the same profit & loss profile ◼ Short Stock and Short Futures show the same profit & loss profile
at different stock price level. at different stock price level.
◼ Call Option ◼ Short Option
➢ when option is in the money (i.e. rising stock price >= call ➢ when option is in the money (i.e. falling stock price <= put
option strike ($100)), it shows the same pattern of profit & option strike ($100)). it shows the same pattern of profit & loss
loss profile (not same p&l amount), because with p&l gap profile (not same p&l amount), because with p&l gap down by
down by call option premium paid ($-10) put option premium paid ($-6)
➢ when option is out of money (i.e. falling stock price < call ➢ when option is out of money (i.e. rising stock price > put option
option strike ($100)), it shows the maximum loss is limited at strike ($100)), the maximum loss is limited at the premium
the premium paid level ($-10) paid level ($-6)
➢ Call Option can replicate the long stock holding with potential ➢ Put Option can replicate the short stock position with potential
gain pattern only when it is in the money: stock price >= stock gain pattern only it is in the money: stock price <= stock price -
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price + option premium paid ($105+$15 = $115) option premium paid ($105-$6 = $94)
Why Hedged by Option?
Buy Stock at Current Stock Price = $105 Buy Stock at Current Stock Price = $105
Short Stock Future Hedge at $105 Long Put at Strike = $100, Put Premium = $10
◼ Future Hedge is a symmetrical hedge, the result P&L ◼ Option Hedge is a non-symmetrical hedge, the result
after hedge with stock is zero regardless of the price P&L at expiry is breakeven and flat when stock price
up or down in the future. move down to or below $115 ; whilst above this will
◼ This is fully hedged and the cost of stock fixed at enjoy the upside gain of the stock.
$105 regardless of the stock price moving up or ◼ This is like buying the insurance to long stock with
down in the future. downside risk protection, but enjoy the upside
potential gain of stock holdings. The insurance cost
is the option premium.
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Option Risk Parameters
❑ Options Risks measure different dimensions of the risks in an
option position.
❑Vega : Volatility
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Option Risk Parameters
Option Price quotation screen with some Greeks Parameters
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Option Risk Parameters - Delta
change in price of option
Delta = ────────────────────────
change in price of underlying asset
◼ Measure the (sensitivity) rate of change of the option price with respect to the price
of the underlying asset (or slope of the option curve)
◼ The absolute value of delta is the probability that the option will be end up in-the-
money at option expiry
◼ It is like the “speed” of option price change over underlying stock price change.
Example
(Option curve before expiry)
Option Value
Assuming other factors constant, a Call option
(Option curve at expiry) with 0.7 delta means
Intrinsic Value
➢ when underlying stock increase by $1, the
call option price will increase by $0.7 (or
Gamma 70% of underlying stock price change)
(slope of slope,
$1 acceleration) ➢ when underlying stock decrease by $1, the
call option price will decrease by $0.7
$0.7
Delta
(slope of option
curve, velocity)
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Option Risk Parameters - Delta
◼ For Long option:
➢ Call delta is always positive : 0 (out-of-the-money) < x < 1 (deep in-the-money)
➢ Put delta is always negative : -1 (deep in-the-money) < x < 0 (out-of-the-money)
➢ At-the-money option: Call delta ~ 0.5, Put delta ~ -0.5
◼ Short option will result in : Call delta is negative and put delta is positive
◼ Delta plays an important role in risk management related to options hedged by
underlying stock positions.
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Delta Hedge
◼ Delta is useful as the Hedge Ratio to establish “delta neutral hedged position” using
the underlying stocks. That is, the equivalent no. of underlying stocks represented by
an option position (or 1 option = ? no. of underlying stocks exposure)
◼ “Position delta” of Option measures net delta effect or the equivalent no. of
underlying stock exposure
◼ Delta Neutral hedge portfolio is a riskless combination of holding position in either
options, stocks or both (e.g. short calls and hedged by long stocks). It is to ensure
“zero Delta” position so that the hedged portfolio p&l will be insensitive to underlying
stock price changes.
◼ For call option hedged by underlying stock,
➢ delta neutral hedge portfolio is long a number of stock to hedge one unit of
short call option so that position delta is zero, or
➢ hedge ratio = the no. of calls to sell to hedge for 1 long stock = 1/ Call delta
◼ For put option hedged by underlying shares,
◼ delta neutral hedge portfolio is long a number of stock to hedge one unit of long
put option so that position delta is zero, or
◼ hedge ratio = the no. of puts to buy to hedge for 1 long stock = 1 / Put delta
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Delta Hedge - Limitation
◼ Delta is dynamic which changes with underlying stock price moves.
◼ Delta at each stock price level holds only for a very small changes in stock
prices.
◼ Hence, Delta neutral hedge requires periodic rebalancing (i.e. dynamic
hedging) when the underlying stock price moves.
◼ Periodic rebalancing will involve high transactions costs which might result in
loss to the delta neutral hedging strategy.
◼ The issues of transaction costs and need for rebalancing applicable both for
selling of call options and buying of put options to derive delta neutral hedge.
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Example - Delta
Example
A Call option price at $8.7 with delta 0.7, what does it means?
◼ when underlying stock price increase by $1, the call option price will increase
by $0.7 (or 70% of underlying stock price change) assuming other factors
constant. The new option price is estimated as $9.4 = $8.7 + $0.7
◼ Hence, holding 1 units of call option, this is equivalent to controlling / holding
0.7 units of stock position exposure.
How to create the delta-neutral hedge strategy for call option?
◼ To create the hedged portfolio of short call option + long stock with zero
position delta (=> offsetting position profit & loss):
◼ hedge ratio = 0.7 delta => 1 unit option = 0.7 unit stock
◼ to hedge 1 units of short call option, need to long 0.7 unit of stock; Or
◼ to hedge 1 unit of stock, the no. of short call option hedge = 1 / 0.7 =
1.43 units of option
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Example (Cont’d)
Example – Continued from previous example.
Call Option price = $8.7 Delta = 0.7
Put Option price = $1.2 Delta = -0.4
Conversion ratio: 1 option = 1 stock
On T, if the Investor short 500 Call option, how many stocks buy to create delta
neutral hedge?
Call Position Delta = no. of option contract x conversion ratio x delta
= 500 x 1 x 0.6846 = 342.3
Hence, for $ 1 increase in stock price, the 500 call option value increased by
$342.3 (in essence, it behaves like holding 342.3 stock)
To hedge short 500 Call option position,
he should long 342.3 (or round to 342) stock position to create the delta
neutral hedge.
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Example – Single Option Delta Hedge
1) Position Delta of Single Stock Option
Position Delta Position Delta
(Shares) (Dollar Value)
No. of Option Conversion Unit of stock Delta Eqv. stock Current Eqv. stock
ratio per 1 Option holding Stock value
(shares) price ($)
500 1 500 0.6846 342.30 $122.00 41,761 342.3 shares x stock price $122
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Example – Single Option Delta Hedge (Re-balancing)
On T+1
If the Stock price moved up from $122 to $123,
Delta moved from 0.6846 to 0.7402
Net Portfolio Position with new Delta -27.80 -$3,419 ** losing money in case of portfolio unwind
◼ Measures of the (sensitivity) rate of change of the delta value with respect to
the change of price of the underlying asset (or the curvature of the option
price or slope of the slope, i.e. convexity)
◼ It measures the “acceleration” of delta change over underlying stock price
change.
Example
If existing Option Call Delta is 0.4, Gamma is 0.1, this means if the stock price
increase by $1, the Delta increase by 0.1. Hence the option premium will be
increase by $0.5 (Delta 0.4 + Gamma 0.1)
◼ Call & Put option with same strike and maturity has same Gamma
◼ Long call and put, Gamma +ve; Short call and put, Gamma is –ve
◼ “Position gamma” of Option measures the net gamma effect of the Position
delta change.
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Gamma (Con’t)
Gamma of Long Call and Put as a ◼ Gamma change as the underlying stock
function of Stock Price price moves,
➢ Gamma increase as stock price move
towards strike X
➢ Gamma decrease as stock price move
away from strike X
◼ Gamma relationship with Option
moneyness
➢ Gamma is the highest when the Option is
ATM (it means Delta is sensitive to stock
price change)
➢ Gamma is about zero when the Option is
deep ITM or OTM (it means delta is
insensitive to stock price change)
◼ Gamma relationship with option maturity
X ➢ For ATM option, Gamma reduces as
maturity of option increases. It is maximum
Stock Price with short time to maturity
➢ For deep ITM or OTM options, Gamma
increases as maturity increases
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Gamma Hedge
◼ Gamma is important because it adjusts the hedging error of Delta Hedge
due to convexity of the non-linear option price curve in order to make it
Gamma neutral.
◼ Gamma hedge in theory will reduce the frequency of periodic rebalancing
based on Delta Hedge (because it adjust the convexity effect as well).
◼ However, Gamma is also dynamic which changes with underlying stock price
moves. Hence, Gamma hedge is also dynamic hedge which requires
periodic rebalancing but in theory should be with lesser frequency compared
to Delta Hedge strategy only.
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Example – Single Option Gamma Hedge
Continued from previous example.
Company A, on T, below is the market data
Stock price = $122
Call Option Strike = 120
Call Option price = $4.03
Delta = 0.6846, Gamma = 0.0583
Conversion ratio: 1 option = 1 stock
On T, if the Investor short 500 Call option, how many stocks buy required to create Gamma Neutral
hedge?
Hence, for $ 1 increase in stock price, the 500 call option Position Delta value increased by $29.15 (in
essence, it behaves like holding 29.15 stock)
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Example – Single Option Gamma Hedge
Call Position Gamma = no. of option contract x conversion ratio x Gamma
= 500 x 1 x 0.0583 = 29.15
After Delta + Gamma neutral hedge on T at stock price $122, the stock holding is:
= Delta Hedge stock holding 342.3 + Gamma Hedge stock holding 29.15
= 371.45 stock
Compared to the previous example on T+1 after stock price move from $122 to $123, required stock
holding for delta hedge re-balancing on T+1
= 370.1 stock
Delta + Gamma Hedge on T improves the Hedging Efficiency of Delta Hedge with closer stock
holding hedge for $1 after stock price increase on T+1. This will reduce the frequency of stock re-
balancing over time.
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Example – Single Option Gamma Hedge
1) Position Delta of Single Stock Option
Position Delta Position Delta
(Shares) (Dollar Value)
No. of Option Conversion Unit of stock Delta Eqv. stock Current Eqv. stock
ratio per 1 Option holding Stock value
(shares) price ($)
500 1 500 0.6846 342.30 $122.00 41,761 342.3 shares x stock price $122
Stock Holding with Delta Hedge => 342.30 $122.00 41,761 342.3 shares x stock price $122
Stock Holding Adjustment for Gamma Hedge => 29.15 $122.00 3,556 29.15 shares x stock price $122
Total Stock Holding hedge with Delta + Gamma Hedge => 371.45 45,317
Previous Example - Stock Holding with new Delta @S=123 => 370.10 $122.00 45,152
Stock Holding difference -1.35 ** Gamma Hedge improve the Hedging Efficiency of Delta Hedge
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Option Risk Parameters - Vega
change in price of option
Vega = ───────────────────
change in volatility
◼ Measures of the (sensitivity) rate of change of the option price with respect to
change in volatility
◼ To buy either put / call option, this is long Vega (or +ve Vega)
◼ To sell either put / call option, this is short Vega (or –ve Vega)
Vega for a long call and put option as a function of Stock Price Vega change as underlying stock price
move
◼ Vega tends to be highest when an option
is at-the-money
Relationship of Vega and stock price &
option strike
◼ Vega falls as the market price and strike
price diverge
Relationship of Vega and option maturity
◼ Vega is lower when option is closer to
expiration 23
Example – Single Option Vega
Company A, below is the market data on T.
Stock price = $122
Call Option Strike = $120
Call Option price = $4.03
Implied Volatility = 10%
Vega = 21.68
Conversion ratio: 1 option = 1 stock
(* Vega ≠ Implied Volatility)
If the Implied Volatility moved by 1% from 10% to 11%, what is the new Call Option price estimate?
If the Investor long Call option on T (long Vega), he will make profit of $0.2168 with the 1% Implied Volatility increase,
assuming all other factors unchanged.
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Option Risk Parameters - Theta
change in price of option
Theta = ─────────────────
change in time
◼ measures of the rate (sensitivity) of change of the option price with respect to the passage of
time
◼ The theta of a long call or put is usually -ve. This means that, if time passes with the price of
underlying asset and its volatility remaining the same, the value of the option ↓
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Example - Theta
When stock price and stock volatility hold constant, if the long call price
Theta is 0.375 over 17 calendar days.
** Note: above is the rough estimate of the Theta time decay impact
assuming that time decay is constant over time.
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Option Risk Parameters - Rho
change in price of option
Rho = ─────────────────────────
change in interest rate
◼ measures of the (sensitivity) rate of change of the option price with respect to
the interest rate
◼ As interest rate increase, call price will rise and put price will fall.
◼ Hence, Rho is +ve for call, -ve for put
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Example – Single Option Vega
Company A, below is the market data on T.
Stock price = $122
Call Option Strike = $120
Call Option price = $4.03
Implied Volatility = 10%
Vega = 21.68
Rho = 19.87
Risk Free Interest Rate = 2.5%
Conversion ratio: 1 option = 1 stock
If the risk free interest rate increased by 1% from 2.5% to 3.5%, what is the new Call Option price
estimate?
If the Investor long Call option on T, he will make profit of $0.1987 with 1% increase in interest rate, assuming all other
factors unchanged.
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Example – Attribution Analysis of Option Price Change
Attribution Analysis is to analyze the breakdown of effect to option premium
change due to each Greeks factor change.
European Option
Implied Volatility 10% 11% 1%
Risk-Free Interest rate 2.50% 3.50% 1%
Time to maturity (days) 90 89 1
Option Strike (X) $120
What is the estimated new Call and Put Option Price on T+1?
Please demonstrate the attribution analysis of the effect to option premium change due to
each Greeks factor change.
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Example – Attribution Analysis of Option Price Change
Option Premium by Black-Scholes Model Calculation:
Using Black-Scholes Model to calculate the new Option price based on T+1
market data.
Option Input
Spot Price 123.00
Strike Price 120.00
Maturity (time to maturity in days) 89
Interest Rate (risk free) - cont compound 3.50%
Volatilty 11.00%
Option Output
Call Premium 5.1321
Put Premium 1.0983
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Example – Attribution Analysis of Option Price Change
Call Option Price T+1 change explained by:
1) The effect on option premium from Delta
change in price of option = Delta x change in price of underlying asset
= 0.6846 x $ 1
= $0.6846
3) The stock volatility effect on option premium from Vega due to Implied
Volatility change
change in price of option = Vega x change in Implied Volatility
= 21.68 x 1%
= +$0.2168
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Example – Attribution Analysis of Option Price Change
4) The time decay effect on option premium from Theta
change in price of option = Theta x change in time
= 0.0176 x 1
= $0.0173
* Note: Time decay is –ve for long call option over time
Hence, change in price of option = - $0.0173 over 1 day
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Example – Attribution Analysis of Option Price Change
Put Option Price change explained by:
1) The effect on option premium from Delta
change in price of option = Delta x change in price of underlying asset
= -0.3154 x $ 1
= $-0.3154
3) The stock volatility effect on option premium from Vega due to Implied
Volatility change
change in price of option = Vega x change in Implied Volatility
= 21.68 x 1%
= +$0.2168
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Example – Attribution Analysis of Option Price Change
4) The time decay effect on option premium from Theta
change in price of option = Theta x change in time
= 0.0092 x 1
= $0.0092
* Note: Time decay is –ve for long put option over time
Hence, change in price of option = - $0.0092 over 1 day
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Example – Attribution Analysis of Option Price Change
The Attribution Analysis of Option Price Change Result
Directional Time Volatility Interest Rate (A) (B)-(A) (B)
BS
Opton Option
Option
Option Premium Delta Gamma Theta Vega Rho Premium Residual
Price
(T0) (T+1)
(T+1)
Call 4.03 0.6846 0.0583 -0.0173 0.2168 0.1987 5.1711 -0.0390 5.1321
16.99% 1.45% -0.43% 5.38% 4.93% 28.32% -0.97% 27.35%
Put 1.28 -0.3154 0.0583 -0.0092 0.2168 -0.0994 1.1311 -0.0328 1.0983
-24.64% 4.55% -0.72% 16.94% -7.77% -11.63% -2.56% -14.20%
Usage: Attribution Analysis can be the sensitivity estimate for the theoretical option premium
derived from all Greek move or respective premium impact due to each Greek factor move.
Limitation: The sensitivity estimate might not be accurate with unexplained residual difference
in case of any significant Greek factor(s) move.
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