Slope of Payoff Profile for Call

Consider the Total Value of a Call Option

∆ (or  ) is dc / dS = slope of payoff profile for a call.

For Call, What is min value of ?

What is max value of ?
What is  of ATM call?
 Option

0 < dc/dS < 1

Total Value
If σ ↑ dc/dS = 1

S
K
dc/dS = 0
 The Greeks: Sensitivities & Delta Hedging

I. Background: Risk, Sensitivities, Derivatives, & Hedge Ratios

A. Risk: Sensitivity to changes in the underlying source of uncertainty.

1. Stock Market: Ri = αi + βi RMt + εi .

Source of uncertainty = Market Return = RM .
Risk = dRi / dRM = βi .
n

2. Bond Market: Bond Price = B = Σ ck / (1 + r)k

k=1

Bond Return = RB = ΔB / B.
Source of uncertainty = Market Interest Rates = r.
Risk = dRB / dr = Duration.
 Risk

4. Hedging with Options:

a. Single-Period Binomial Model:

Options Hedge Ratio: Δ = (cu - cd) / (Su - Sd) = dc / dS.

b. Black / Scholes Model: c = S * N(d1) - Ke -rT * N(d2)

Options Hedge Ratio: dc / dS = N(d1).

The Point: Hedge Ratios are derivatives --

measures of sensitivity, risk.

They also show how many futures or options are needed to hedge.
 Motivation behind the Greeks

1. Banks sell products involving options.

Bank are short options! Need to hedge!

2. Examples:
a. Currency Options.
i. Corporate clients can buy FX options through exchange or OTC.
ii. Banks sell FX options to meet clients’ needs.

b. Equity Options.
i. Bank underwrites equity issue.
Guarantees issue price. (Bank will buy @ K if they can’t sell.)
Effectively sells put option to firm’s owners.
ii. Bank sells products that:
a. Guarantee no loss of principal on a market investment;
b. Guarantee return as some proportion of market return.
c. These products have embedded options on the market.
 Delta Neutral Hedging
B/S Model: c = S * N(d1) - Ke-rT * N(d2)
A. To hedge the position, how many calls should be sold for every share
owned?
(i.e., what is the right hedge ratio to eliminate risk?)

1. Define:  = c / S = dc / dS = N(d1); Sensitivity of c to changes in S.

a. When S  by $1, c  by $.
b. Example: If  = .5, when S↓ by $1, c↓ by $.50

2. Hedge ratio = 1 /  = 1 / N(d1).

a. To hedge, sell 1 /  calls for every share owned.
b. Then, when S  by $1, short call position  by $1.
c. Example: If  = .5, sell 1 /  = 2 calls;
when S  $1, the 2 short calls ↑ $1. Hedged.

3. In general, Hedge Portfolio is long QS shares & short QC calls.

a. -neutral Hedge Portfolio = HP = QS (S) - QC (c).
b. Let QS = 1 share; QC = 1 /  = 1 / (c/S).
c. Then HP = 1 * (S) - [ 1 / (c/S) ] * (c)
 © Kelly D. Welch 1-7

 d1 = [log(S/X) + (r + 1/2σ2)τ]/σ √τ
 d2 = d1 - σ √τ
 d1 is the probability that the stock price will be in the
money at expiration.
 Intuition behind Delta Neutral Hedging
( & ) (theta) (vega) (rho)

c = f (S, K, T, , r)

B. Intuition:  (or ∆) is the slope of the payoff profile for an option.

 Intuition behind Delta Neutral Hedging
( & ) (theta) (vega) (rho)

c = f (S, K, T, , r)
B. Intuition:  can be thought of as follows
1. 0 < || < 1; ( can be negative);

2. ATM call should have   0.5;

( = 50% chance to be ITM)

3. ITM call should have .5 <  < 1;

( > 50% chance to be ITM)

4. OTM call should have 0 <  < .5;

( < 50% chance to be ITM)
Intuition behind Delta Neutral Hedging
 Other Characteristics of 

1. Put options have ’s the opposite sign;

a. long position in ATM puts:   -.5;
b. long position in ITM puts: -1 <  < -.5;
c. long position in OTM puts: -.5 <  < 0.

2. Sign of  depends on call or put, long or short: call put

long + -
short - +

3.  = f( S, T, r,  ); i.e., Hedge ratio changes! (theta, vega, vanna, vomma,…)

4. As time passes, extrinsic value : C

a. call ’s move away from +.5; |

b. put ’s move away from -.5 |
(toward 0 and 1 or 0 and -1). |
|
5. As  , opposite; extrinsic value : |
a. call ’s move toward +.5; |______________________ S
b. put ’s move toward -.5. K
 Hedging Ownership of Underlying Asset (+S)

1. Long position in stock (+S) has  = +1. Short position has  = -1.
2. Hedge ratio = 1 /  (= how many options to trade), where  = dc / dS.
3. Example: Suppose call option’s  = .4;
Hedge Ratio = 1 /  = 1 / (.4) = 2.5; Sell 2½ calls for each share owned.
a. Long 1 share:  = +1
b. Short 2½ calls:  = 2.5*(-.4) = -1
c. Net delta:   = 0 Hedged!

4. To establish  - neutral hedge, ’s must sum to 0.

a. As long as net delta  0, any combination of puts, calls, & stocks
with different K’s & T’s can be used.

5. While position may be  - neutral when established,

this will change over time as S, T, and  change.
a. To remain  - neutral, position needs continual adjustment.
Dynamic hedging strategy! (Not hedge & forget.)
 Other Option Sensitivities (Greeks)

A. Gamma () = d / dS = d(dc/dS) / dS = d2c / dS2 .

1. Second derivative; rate of change of rate of change; curvature.
a.  measures speed of change in c as S changes;
b.  measures its acceleration or convexity. (curvature)

2. Gamma is a measure of stability of .

a. Large , unstable ; Small , stable .
b. Low  positions are preferable for -neutrality.
 Theta (T) = dc/dT (Time Decay)
value
1. Graph. |
|
Value decays over time
|
|
|________________________________ T
days remaining 135 90 45 expiration
 Vega () = dc/dσ

1. Characteristics of Vega:

a. As S → K, vegas increase.

b. As T decreases toward 0, Vega’s .

2. Summary of Vega implications:

a. Positive Vega (e.g. long options) - if , value ;

Negative Vega (e.g. short options) - if , value ;

b. Make portfolio Vega-neutral;

Then if  changes, value of portfolio does not change.
 Second Order Greeks: Vanna, Vomma, …

1. Vanna = d(delta) / d(vol) = d(δ) / d(σ) What happens to δ, & ν :

- as time passes ( T↓ ) ?
2. Charm (delta bleed) = d(δ) / d(T) - as vol increases ( σ↑ ) ?

3. Vega = ν = d(c) / d(σ)

4. Vomma = d(vega) / d(implied vol) = d(ν) / d(σ) = d2(c) / d(σ)2

5. d(Vega) / d(Time) = d(ν) / d(T)