The Greek Letters

Chapter 17

1
 The Greeks are coming!
The Greeks are coming!
Parameters of SENSITIVITY
Delta =
Theta =
Gamma =
Vega =
Rho =
2
 c = SN(d1) Ker(T t)N(d2)
p = Ker)T t)N(-d2) SN(-d1)
Notationally:
c = c(S; K; T-t; r; )
p = p(S; K; T-t; r; )
Once c and p are calculated, WHAT IF?

3
 The GREEKS are measures of
sensitivity. The question is how
sensitive a positions value is to
changes in any of the variables that
contribute to the positions market
value.These variables are:
S, K, T-t, r and .
Each one of the Greek measures
indicates the change in the value of
the position as a result of a small
change in the corresponding variable.
Formally, the Greeks are partial 4
 Delta =
In mathematical terms DELTA is the
first derivative of the options
premium with respect to S. As such,
Delta carries the units of the options
price; I.e., $ per share.
For a Call: (c)= c/S
For a Put: (p) = p/S
Results: (p) = (c) - 1
5
 THETA
Theta measures are given by:
(c) = c/(T-t) (p) = p/(T-t)

s are positive but the they are

reported as negative values. The
negative sign only indicates that as
time passes, t increases, time to
expiration, T t, diminishes and so
does the options value, ceteris
paribus. This loss of value is labeled
the options time decay. 6
 GAMMA
Gamma measures the change in delta
when the price of the underlying asset
changes.
Gamma is the second derivative of the
options price with respect to the
underlying price.
(c) = (c)/S = 2c/ S2
(p) = (p)/S = 2p/ S2
Results: (c) = (p)
7
(S) = 0.
 VEGA
Vega measures the sensitivity of the
options market price to small
changes in the volatility of the
underlying assets return.
(c) = c/
(p) = p/
Thus, Vega is in terms of

$/1% change in .
(S) = 0. 8
 RHO
Rho measures the sensitivity of the
options price to small changes in
the rate of interest.
(c) = c/r
(p)= p/r
Rho is in terms of $/%change of r.
(S) = 0.

9
 Example:
S=100; K = 100; r = 8%; T-t =180
days;

= 30%. Call Put

Premium $10.3044 $6.4360
The Greeks:
Delta = 0.6151 -
0.3849
Theta = -0.03359 -0.01252
Gamma = 0.0181
0.0181 10
Again. the Delta of any position
measures the $ change/share in
the positions value that ensues
a small change in the value of
the underlying.
(c)= 0.6151
(p) = - 0.3849

11
 Call Delta (See Figure 15.2, page 345)
Delta is the rate of change of the call
price with respect to the underlying

Call price

Slope =
C
A Stock price
12
 THETA
Theta measures the sensitivity of the options
price to a small change in the time
remaining to expiration:

(c) = c/(T-t) (p)= p/(T-t)

Theta is given in terms is $/1 year.
(c) = - $12.2607/year if time to
expiration increases (decreases) by
one year, the call price will increase
(decrease) by $12.2607. Or,
12.2607/365 = 3.35 cent per day. 13
 GAMMA
Gamma measures the change in delta
when the price of the underlying asset
changes.
= 0.0181. (c) = .6151; (p) =
-.3849.
If the stock price increases to $101:
(c) increases to .
6332 (p) increases to
-.3668.

If the stock price decreases to $99:14

 VEGA
Vega measures the sensitivity of
the options market price to
small changes in the volatility
of the underlying assets return.
= .268416
(Check on Computer)

15
 RHO
Rho measures the sensitivity of
the options price to small
changes in the rate of interest.

Rho = Call Put

.252515
-.221559
Rho is in terms of $/%change of r.
(check on computer)
16
 DELTA-NEUTRAL POSITIONS
A market maker wrote n(c) calls and
wishes to protect the revenue against
possible adverse move of the
underlying asset price. To do so,
he/she uses shares of the underlying
asset in a quantity that GUARANTEES
that a small price change will not have
any impact on the call-shares position.
Definition: A portfolio is Delta-neutral
if
17
 DELTA neutral position in the simple
case of call-stock portfolios.
Vportfolio = Sn(S) + cn(c;S)
(portfolio) = (S)n(S) + (c)n(c;S)
(portfolio) = 0 n(S) + (c)n(c;S) = 0.
n(S) = - n(c;S)(c).
The call delta is positive. Thus, the
negative sign indicates that the calls
and the shares of the underlying asset
must be held in opposite direction.
18
 EXAMPLE: call - stock portfolio
We just sold 10 CBOE calls whose
delta is $.54/shares. Each call covers
100 shares.
n(S) = - n(c;S)(c).
(c) = 0.54 and n(c) = -10.
n(c;S) = - 1,000 shares.
n(s) = - [ - 1,000(0.54)] = 540.
The DELTA-neutral position consists of
the 10 short calls and 540 long shares.
19
 The Hedge Ratio c
Definition: Hedge ratio.

Hedge Ratio
The number of shares required to neutralize the portfolio

The number of shares covered by the options

In the example:
Hedge ratio = 540/1,000 = .54
Notice that this is nothing other than
(c).
20
 In the numerical example, Slide 9:
The hedge ratio: (c) = 0.6151
With 100 CBOE short calls:

n(S) = -(c)n(c;S).
n(c;S) = -10,000.
n(S) = -(.6151)[-10,000] = +6,151
shares The value of this portfolio is:
V = -10,000($10.3044) +
6,151($100)
V = $512,056 21
 Suppose that the stock price rises
by $1.
SNEW = 100 + 1 = $101/share.

V = - 10,000($10.3044 + $.6151)

+6,151($101)

V = - 10,000($10.3044) +
6,151($100)
- 10,000($.6151) + $1(6,151)
22
V = $512,056 - $6,151 + $6,151
 Suppose that the stock price falls
by $1.
SNEW = 100 - 1 = $99/share.

V = - 10,000($10.3044 - $.6151)
+6,151($99)

V = - 10,000($10.3044) +
6,151($100)
- 10,000( - $.6151) - $1(6,151)

V = $512,056 + $6,151 $6,151

23
 In summary:
The portfolio consisting of 100 short
calls and 6,151 long shares is

delta- neutral.
Price/share: +$1 -$1
shares +$6,151 -
$6,151
calls +(-$6,151) -(-
$6,151)
Portfolio $0 24
$0
 DELTA neutral position in the simple
case of put-stock portfolios.
Vportfolio = Sn(S) + pn(p;S)
(portfolio) = (S)n(S) + (p)n(p;S)
(portfolio) = 0 n(S) + (p)n(p;S) =
0.
n(S) = - n(p;S)(p)
Since the put delta is negative, then
the negative sign indicates that the
puts and the underlying asset must be
25
held in the same direction.
 EXAMPLE: put stock portfolio.
We just bought 10 CBOE puts whose
delta is -$.70/share. Each put covers
100 shares. n(S) = -
n(p;S)(p).
(p) = -.70 and n(p) = 10.
n(p;S) = 1,000 shares.
n(S) = - 1,000(-.70) = 700.
The DELTA-neutral position consists of
the 10 long puts and 700 long shares.
26
Portfolio: The portfolio consisting of
10 long puts and 700 long shares is

delta- neutral.
Price/share: +$1 -$1
shares +$700 -$700
puts -$700 $700
Portfolio $0 $0

27
 In the numerical example, Slide 9:

The hedge ratio: (p) = -0.3849

The Delta neutral position with 100
CBOE long puts requires the holding
of:
n(S) = -(p)n(p;S)
n(S) = -(-.3849)[10,000] =
+3,849shares The value of this
portfolio is:
V = 10,000($6.4360) +
3,849($100) 28
 Suppose that the stock price rises
by $1.
SNEW = 100 + 1 = $101/share.

V = 10,000($6.4360 - .3849)

+3,849($101)

V = 10,000( $6.4360) 3,849($100)

- 10,000(.3849) + $1(3,849)

V = $449,260- $3,849 + $3,849

29
 Suppose that the stock price falls
by $1.
SNEW = 100 - 1 = $99/share.

V = 10,000($6.4360 + $.3849)
+3,849($99)

V = 10,000( $6.4360) + 3,849($100)

10,000($.3849) - $1(3,849)

V = $449,260+ $3,849 - $3,849

30
V = $449,260.
 In summary:
The portfolio consisting of 100 long
puts and 6,151 long shares is

delta- neutral.
Price/share: +$1 -$1
shares +$3,849 -
$3,849
calls +(-$3,849) -(-
$3,849)
Portfolio $0 31
$0
An extension:
calls, puts and the stock positio
Vportfolio = Sn(S) + cn(c;S) + pn(p;S)
portfolio = (S)n(S) + (c)n(c;S) +
(p)n(p;S).
But S = 1.
Thus, for delta-neutral portfolio:
portfolio = 0 and
32
EXAMPLE: We short 20 calls and 20
puts whose deltas are $.7/share and -
$.3/share, respectively. Every call and
every put covers 100 shares.
How many shares of the underlying
stock we must purchase in order to
create a delta-neutral position?
n(S) = -(c)n(c;S) + [-(p)]n(p;S).
n(S) = -(.7)(-2,000) [-.3](-2,000)
n(S) = 800.
33
 Example continued
The portfolio consisting of 20 short
calls, 20 short puts and 800 long
shares is
delta- neutral.
Price/share: +$1 -$1
shares +$800 -$800
calls -$1,400 +
$1,400
Puts +$600 -$600
34
 EXAMPLES
The put-call parity:
Long 100 shares of the underlying
stock,
long one put and short one call on this
stock is always delta-neutral:
(position)
= 100 + (p)n(p;S) + (c)n(c;S)

= 100 + [(c) 1](100) + (c)(-100)

35
 EXAMPLES
A long STRADDLE:
Long 15 puts and long 15 calls
(same underlying asset, K and T-t),

with: (c) = .64; (p) = - .36.

(straddle) = 15(100)[.64 + (- .
36)]
=$420/share.
Long 420 shares to delta neutralize
36
 Results:
1.The deltas of a call and a put on the
same underlying asset, (with the
same time to expiration and the
same exercise price) must satisfy
the following equality:
(p) = (c) - 1
2. Using the Black and Scholes
formula:

(c) = N(d1) 0 < (c) < 1

37
38
39
40
41
 THETA
Theta measures the sensitivity of the
options price to a small change in
the time remaining to expiration:
(c) = c/(T-t)
(p)= p/(T-t)
Theta is given in terms is $/1 year.
Thus, if (c) = - $20/year, it means that
if time to expiration increases
(decreases) by one year, the call price
will increase (decreases) by $20. Or,42
43
44
45
46
 GAMMA
Gamma measures the change in delta
when the market price of the
underlying asset changes.
(c) = (c)/S = 2c/ S2
(p) = (p)/S = 2p/ S2
Results:
(c) = (p)
(S) = 0.
47
 GAMMA
In general, the Gamma of any portfolio
is the change of the portfolios delta
due to a small change in the
underlying asset price.
As the second derivative of the
options price with respect to S,
Gamma measures the sensitivity of
the options price to large
underlying assets price changes.
May be positive or negative.
48
 Interpretation of Gamma
The delta neutral position with 100
short calls and 6,151 long shares has
= -$181
Position
value $512,056

75 100 125 S
More negative

Negative Gamma means that the

position loses value when the stock
price moves more and more away from
49
 Interpretation of Gamma

S S

Positive Negative Gamma

Gamma 50
 Result: The Gammas of a put and a
call are equal. Using the Black and
Shcoles model:
(c) = n(d1) and (p) = n(d1) 1.
Clearly, the derivatives of these
deltas with respect to S are equal.
EXAMPLE: (c) = .70; (p) = - .30;
= .2345.
Holding a long call and a short put
has: = .70 - (- .30) = 1.00.
51
EXAMPLE:
(c) = .70, (p) = - .30 and let gamma be .
2345.
Holding the underlying asset long, a long put
and a short call yields a portfolio with:
= 1 - .70 + (- .30) = 0 and
= 0 - 0,2345 + 0,2345 = 0,
simultaneously! This portfolio is

delta-gamma-neutral.
52
53
54
55
 VEGA
Vega measures the sensitivity of the options
market price to small changes in the
volatility of the underlying assets return.

(c) = c/
(p) = p/

Thus, Vega is in terms of $/1% change in

56
57
58
59
60
 RHO
Rho measures the sensitivity of the options
price to small changes in the rate of interest.
(c) = c/r
(p) = p/r

Rho is in terms of $/%change of r.

61
62
63
64
65
 SUMMERY OF THE GREEKS

Position Delta Gamma Vega Theta

Rho
LONG STOCK 1 0 0 0
0
SHORT STOCK -1 0 0 0
0
LONG CALL + + + -
+
SHORT CALL - - - +
- 66
 The sensitivity of portfolios, a
summary.
1.A portfolio is a combination of
securities and options.
2.All the sensitivity measures are
partial derivatives.
3.Theorem(Calculus): The derivative
of a linear combination of functions
is the combination of the derivatives
of these functions. Thus, the
sensitivity measure of a portfolio of
67
securities is the portfolio of these
Example:The DELTA of a portfolio of 5
long CBOE calls, 5 short puts and 100
shares of the stock long:
(portfolio) = (500c - 500p +
100S)
= (500c - 500p + 100S)/S
= 500c/S - 500p/S +
100
= 500c - 500p + 100
This delta reveals the $/share change
in the portfolio value as a function68 of
Example: S = $48.57/barrel.
1 call = 1,000bbls.
Call Delta Gamma
A $0.63/bbl $0.22/bbl
B $0.45/bbl $0.34/bbl
C $0.82/bbl $0.18/bbl
Portfolio:
Long: 3 calls A; 2 calls C; 5,000
barrels. Short: 10 calls B.
69
Example:
= (0.63)3,000+ (0.82)2,000
+ (1)5,000 + (0.45)(-10,000)

= (0.22)3,000+ (0.18)2,000
+ (0)5,000 + (0.34)(-10,000)
= $4,030.
= - $2,380.

70
 = 4,030 a small change of the
oil price, say one cent per barrel, will
change the value of the above
portfolio by $40.30 in the same
direction.
= - 2,380 a small change in the
oil price, say one cent per barrel, will
change the delta by $23.80 in the
opposite direction.
Also, Gamma is negative when the
price per barrel moves away from
$48.57, the portfolio value will 71
A financial institution holds:
5,000 CBOE calls long; delta .4,
6,000 CBOE puts long; delta
-.7,
10,000 CBOE puts short; delta
-.5,
Long 100,000 shares
(portfolio) = (.4)500,000 +
(-.7)600,000
+(-.5)[-1,000,000]
72
 GREEKS BASED STRATEGIES
Greeks based strategies are opened
and maintained in order to attain
a specific level of sensitivity.
Mostly, these strategies are set
to attain zero sensitivity. What
follows, is an example of
strategies that are:
1.Delta-neutral
2.Delta-Gamma-neutral
3.Delta-Gamma-Vega-Rho-neutral73
EXAMPLE:
The underlying asset is the a stock.
The options on this stock are
European.
S = $300; K = $300; T = 1yr; =
18%; r = 8%; q = 3%.
c = $28.25.
= .6245
= .0067
= .0109 74
 DELTA-NEUTRAL
Short 100 calls. n0 = - 10,000; Long nS = 6,245
shares
Case A1: S increases from $300 to
$301.
Portfolio Initial Value New value Change
-100Calls - $282,500 - $288,800
- $6,300
6,245S $1,873,500 $1,879,745 $6,245
Error: -
$55
Case A2: S decreases from $300 to
$299.
75
Case B1: S increases from $300 to
$310.
Portfolio Initial Value New value Change
-100Calls - $282,500 - $348,100
- $65,600
6,245S $1,873,500 $1,935,950 $62,450
Error: -
$3,150
The point here is that Delta has changed
significantly and .6245 does not apply any more.
S = $300 $301 $310
= .6245 .6311 .6879.
We conclude that the delta-neutral portfolio must
76
Call #0 Call #1
S = $300 S = $300
K = $300 K = $305
T = 1yr T = 90 days
= 18% r = 8% q = 3%
c = $28.25 c = $10.02
= .6245 = .4952
= .0067 = .0148
= .0109 = .0059
= .0159 = .0034 77
 A DELTA-GAMMA-NEUTRAL PORTFOILO
(portfolio) = 0: nS + n0(.6245) + n1(.4952) = 0
(portfolio)= 0: n0(.0067) + n1(.0148) = 0
Solution:
n0 = -10,000
n1 = - (-10,000)(.0067)/.0148 = 4,527
nS = - (-10,000)(.6245) (4,527)(.4952) = 4,003
Short the initial call : n0 = -10,000
Long 45.27 of call #1 n1 = 4,527
78
 THE DELTA-GAMMA-NEUTRAL PORTFOLIO
Case A1: S increases from $300 to $301.
Portfolio Initial value New value Change
0) -10,000 - $282,500 - $288,800 -$6,300
1) 4,527 $45,360 $47,657 $2,297
S) 4,003 $1,200,900 $1,204,903 $4,003
Error: 0
Case B1: S increases from $300 to $310.
Portfolio Initial value New value Change
0) -10,000- $282,500 - $348,100 - $65,600
1) 4,527 $45,360 $70,930
$25,570
S) 4,003 $1,200,900 $1,240,930 $40,030
Error: 0
79
If we examine the exposure level to all parameters,
however, we observe that:

Portfolio Delta Gamma Vega Rho

-10,000 - 6,245 - 67 - 109 - 159
4,527 2,242 67 27 15
4,003S 4,003 0 0 0
Risk 0 0 - 82 - 144

The above numbers reveal that the Delta-

Gamma-neutral portfolio is exposed to risk
associated with
the volatility and the risk-free rate 80
Case C1:
S increases from $300 to $310
and simultaneously,
r increases from 8% to 9%.
Portfolio Initial value New value Change
-10,000 - $282,500 - $330,500 - $48,000
4,527 $45,360 $73,166 $27,806
4,003S $1,200,900 $1,240,930 $40,030
Error: - $10,756
81
Delta-Gamma-Vega-Rho-neutral
portfolio
CALL 0 1 2 3
K 300 305 295 300
T(days) 365 90 90 180
Volatility 18% 18% 18% 18%
r 8% 8% 8% 8%
Dividends 3% 3% 3% 3%
c $28.25 $10.02 $15.29 $18.59
82
 Delta-Gamma-Vega-Rho-neutral portfolio
CALL
0 .6245 .0067 .0109 .0159
1 .4954 .0148 .0059 .0034
2 .6398 .0138 .0055 .0044
3 .5931 .0100 .0080 .0079

S 1.0 0.0 0.0 0.0

83
 The DELTA-GAMMA-VEGA-RHO-
NEUTRAL-PORTFOLIO
In order to neutralize the portfolio to
all risk exposures, following the sale
of the initial call, we now determine
the portfolios holdings such that all
the portfolios sensitivity parameters
are zero simultaneously.
= 0 and = 0 and = 0 and =
0 simultaneously!

84
=0
nS+n0(.6245)+n1(.4954)+n2(.6398)+n3(.5931)
=0

=0
n0(.0067)+n1(.0148)+n2(.0138)+n3(.0100)
=0

=0
n0(.0109)+n1(.0059)+n2(.0055)+n3(.0080)
=0 85
The solution is:

Exact n
Short 100 CBOE calls #0; -10,000
Short 339 calls #1; -33,927
Long 265 calls #2; 26,534
Long 204 calls #3; 20,420
Short 6,234 shares. -6,234

86
Case D: S increases from $300 to $310
r increases from 8% to 9%
increases from 18%
to 24%
Portfolio Initial Value
New value
0) - 10,000 - $282,468 - $428,071
S) - 6,234 - $1,870,200 - $1,932,540

1) - 33,927 - $340,023 - $664,552

2) 26,534 $405,668
$694,062 87
 DYNAMIC DELTA - HEDGING
The market stock price keeps
changing all
the time. Thus, a static DELTA- neutral
hedge is not sufficient.
A continuous delta adjustment is not
practical.
An adjusted Delta-neutral Position:
1.Every day, week, etc.
88
 DYNAMIC DELTA HEDGING
Market makers provide traders with
the options they wish to trade. For
example, if a trader wishes to long
(short) a call, a market maker will
write (long) the call. The difference
between the buy and sell prices is
the market makers

bid-ask spread.
The main problem for a market maker
who shorts calls is that the premium
received, not only may be lost, but
89
 DYNAMIC DELTA - HEDGING
Recall: The profit profile of an
uncovered call is:
P/L At expiration

c
K ST

90
 DYNAMIC DELTA - HEDGING
Recall: The profit profile of a
covered call is:
Strategy IFC At expiration
ST < K ST > K
Short c 0 -(ST K)
call
Long -St ST ST
stock
Total - St + c ST K
P/L ST - St + K - St91+
 DYNAMIC DELTA - HEDGING
Recall: The profit profile of a covered
call is:
P/L At expiration

K St+ c
K ST

-St + c
92
 DYNAMIC DELTA - HEDGING
The Dynamic Delta hedge is based on
the
impact of the time decay on the call
S
Delta. ln[ ] [r .5 ][T t]
t 2

Recalldthat: K
1
Tt
and
N(d1 ) (c) 93
 DYNAMIC DELTA - HEDGING
Observe what happens to d1
when T-t 0.

1. For:St > K d1 and

N(d1) = (c) 1

2. For:St < K d1 - and

N(d1) = (c) 0
94
 DYNAMIC DELTA - HEDGING
The Dynamic hedge:
1.Write a call and simultaneously,
hedge the call by a long Delta
shares of the underlying asset. As
time goes by, adjust the number of
shares periodically.
Result: As the expiration date nears,
delta:
goes to 0 in which case you wind
up without any shares.
95
 DYNAMIC DELTA - HEDGING

St : St < K St > K
(c): 0 1
Call: uncovered fully covered
n(S): 0 n(c;S) 1

96
Table 15.2 Simulation of Dynamic delta - hedging.(p.364)
Cost of
Stock Shares shares Cummulative
Interest
Week przce Delta purchased purchased cost cost
($000) ($000)
($000)
0 49.00 0.522 52,200 2,557.8 2,557.8
2.5
1 48.12 0.458 (6,400) (308.0) 2,252.3
2.2
2 47.37 0.400 (5,800) (274.7) 1,979.8
1.9
3 50.25 0.596 19,600 984.9 2,966.6
2.9
4 51.75 0.693 9,700 502.0 3,471.5
3.3
5 53.12 0.774 8,100 430.3 3,905.1
3.8
6 53.00 0.771 (300) (15.9) 3,893.0
3.7
7 51.87 0.706 (6,500) (337.2) 3,559.5
3.4
8 51.38 0.674 (3,200) (164.4) 3,398.5
3.3
9 53.00 0.787 11,300 598.9 4,000.7
3.8 97
Table 15.3 Simulation of dynamic Delta - hedging. (p. 365)
Cost of
Stock Shares shares Cumulative I
nterest
Week price Delta purchased purchased cost cost
($000) ($000) ($000)
0 49,00 0.522 52,200 2,557.8 557.8
2.5 1 49.75 0.568 4,600 228.9
2,789.2 2.7 2 52.00 0.705
13,700 712.4 3,504.3 3.4 3 50.00
0.579 (12,600) (630.0) 2,877.7 2.8
4 48.38 0.459 (12,000) (580.6) 2,299.9
2.2 5 48.25 0.443 (1,600) (77.2)
2,224.9 2.1 6 48.75 0.475 3,200 156.0
2,383.0 2.3 7 49.63 0.540 6,500
322.6 2,707.9 2.6 8 48.25 0.420
(12,000) (579.0) 2,131.5 2.1 9
48.25 0.410 (1,000) (48.2) 2,085.4
2.0 10 51.12 0.658 24,800 1,267.8
3,355.2 3.2 11 51.50 0.692 3,400
175.1 3,533.5 3.4 12 49.88 0.542
(15,000) (748.2) 2,788.7 2.7 13
49.88 0.538 (400) (20.0) 2,771.4
2.7 14 48.75 0.400 (13,800) (672.7)
2,101.4 2.0 15 47.50 0.236 (16,400)
(779.0) 1,324.4 1.3 16 48.00 0.261 2,500
120.0 1,445.7 1.4 17 9846.25