GREEK LETTERS
What are Greeks ??
Greeks are statistical values that show the sensitivity of the
price of an option to the factors that determine the value
of an option
They can be used as indicators to help monitor and analyze
the risks associated with portfolios which include options
Greeks include:
Delta
Gamma
Vega
Theta
Rho
Delta  It is the rate of change in the price of the
stock option to a change in the price of the
underlying
Gamma  It is the rate of change of delta with
respect to the underlying asset price
Theta  It is the rate of change of the value of the
portfolio with respect to the passage of time
Vega  It is the rate of change of the value of the
portfolio with respect to the change in volatility
Rho  It is the rate of change of the value of the
portfolio with respect to the change in risk free
interest rates
DELTA
Delta is the rate of change in the price of the stock option to a
change in the price of the underlying
A delta of .5o means that a Re 1 increase in the price of the
underlying asset will increase the price of the option by
approximately Re .50
Delta is also known as the HedgeRatio
Delta = change in the option price
change in the stock price
Characteristics of delta:
The delta of call options (long call and short put) has positive value
The delta of put options (short call and long put) has negative value
The delta of the underlying is always constant at 100
All call and put options that are at the money have delta of around 050
and 050 respectively
Delta for long futures is +1
Delta for short futures is 1
CHARACTERISTICS
CHARACTERISTICS
The value of delta moves far from zero as the option moves into the
money
The value of delta approaches zero as the option moves out of the money
Option
Delta values
OTM ATM ITM
Long Call / Short Put 0 +050 +100
Short Call / Long Put 0 050 100
Example: Strike price = Rs 30; time to expiry = 54 days,
volatility = 25 % and rate of interest = 6%
CHARACTERISTICS
DELTA SENSITIVITY
DELTAS SENSITIVITY TO VOLATILITY AND TIME TO MATURITY
As time to maturity increases or volatility increases all options become
more like ATM with their deltas approaching 05
Conversely as time to maturity or volatility decrease, delta moves away
from 05 levels
For ITM calls delta moves towards 1 and for OTM calls delta moves
towards 0 as time to maturity or volatility decreases
DELTA VS TIME TO EXP
CALL DELTA VS TIME TO EXP
0.000000
0.200000
0.400000
0.600000
0.800000
1.000000
1.200000
0
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5
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TIME TO EXP
D
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A
DELTA VS TIME TO EXP
ATM
DELTA VS TIME TO EXP
INM
DELTA VS TIME TO EXP
OTM
DELTA HEDGING
DELTA HEDGING:
Delta is used for hedging of options
By taking an opposite position in the underlying instrument equal in
size to the options delta, we immunize the position against profit
or loss variability due to small movements in the market This is
referred to as delta hedging or creating a deltaneutral portfolio
The delta neutral implies a strategy wherein the sum of all deltas in
a portfolio is equal to zero
Example: Assume that the stock price is Rs 200 and the option
premium is Rs 20 and an investor has sold 10 call option contracts
(1000 shares) Suppose delta in this case is 060
Now to hedge, the investor would have to go long on the
underlying by
Delta x number of shares traded in option
Hence, hell buy 06 (delta) x 1000(no of shares short in option) =
600 shares
DELTA HEDGING
Assume that the price of the underlying goes up by Re1
Profit on the underling:
Investor has purchased 600 shares @ Rs 200 = Rs 1,20,000
Current price of share = Rs 201
Hence his profit in the underlying will be (201 x 600)  1,20,000 = Rs 600
Loss on the option:
The option price will also go up by 06 x Re1 = 60 paise and now the option
price would be Rs 20.60
The investor sold 10 call options @ Rs 20
Hence his loss on the option will be (Rs 2060  Rs 2000) x 1000 = Rs 600
Here, we can see that loss in options was offset by profit in underlying stock
DELTA HEDGING
Now, assume that the price of the underlying goes down by Re1
Loss on the underling:
Investor has purchased 600 shares @ Rs 200 = Rs 1,20,000
Current price of share = Rs 199
Hence his loss in the underlying will be 1,20,000  (199 x 600)= Rs 600
Profit on the option:
The option price will also go down by 06 x Re1 = 60 paise and now the option
price would be Rs 1940
The investor sold 10 call options @ Rs 20
Hence his profit on the option will be (Rs 200  Rs 1940) x 1000 = Rs 600
An investor has to delta hedge constantly in order to make a profit or to
maintain his risk less position because delta does not remains constant
and changes during the life time of the option
ISSUES IN DELTA HEDGING
The log normal assumption may not be valid
The volatility estimate may not be correct
The hedge may not be done frequently enough to prevent
losses due to or gamma risks
DELTA HEDGING
GAMMA
GAMMA:
Gamma is the rate of change of delta with respect to the underlying asset
price
For example:
Spot Price Delta Gamma
XYZ Aug 50 call Rs 480 +045 007
Rs 490 +052
Rs 470 +035
If gamma is small, delta changes slowly whereas if gamma is large delta is
very sensitive to the price of the underlying
gamma = change in the value of the portfolio * change in time
change in stock price
GAMMA
Characteristics of gamma:
Gamma of call and put is similar
Gamma of long positions (ie long calls and long puts)
is positive
Gamma of short positions (ie short calls and short puts) is
negative
Gamma of underlying stock is zero
Gamma is highest of atthemoney option
The further an option goes in or outofmoney, the smaller
the gamma becomes
Shortterm options have higher gamma than longterm
options
GAMMA
SENSTIVITY OF GAMMA:
Before going into the details remember one important principle
The magnitude of gamma is consistent with the uncertainty whether the
option will expire in or out of money
Greatest for ATM options ( uncertainty is maximum)
The gamma for ITM and OTM options increase with the increase in
volatility and time to maturity ( uncertainty increases)
Gamma for ATM option falls with the increase in volatility and increase in
time to maturity ( is the uncertainty decreasing?)
GAMMA VS VOLATILITY
GAMMA VS VOL
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VOLATILITY
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GAMMA VS VOL INM
GAMMA VS VOL OTM
GAMMA VS. VOL ATM
GAMMA VS TIMETO EXPIRATION
GAMMA VS TIME TO EXP ATM
0
0.1
0.2
0.3
0.4
0.5
0.6
0.5 0.45 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0.03 0.01
TIME TO EXPIRATION
G
A
M
M
A
GAMMA VS
EXP ATM
GAMMA VS
EXP INM
GAMMA VS
EXP OTM
GAMMA VS SPOT PRICE
GAMMA VS SPOT PRICE
0
0.01
0.02
0.03
0.04
0.05
0.06
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SPOT PRICE
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Series1
GAMMA
Example: Strike price = Rs 115; volatility = 60 %, rate of interest = 10%
and time to expiry = 3 months, 6 months and 1 year
GAMMA RISK
MOST IMPORTANT THING TO UNDERSTAND:
The holder of an option who is short delta units of the underlying (long
call) will achieve a positive cash flow if subsequently the price movement
is sufficiently large and a negative cash flow if price movement is
sufficiently small
Though theta and gamma are equal and opposite ,theta is more or less
fixed in terms of loss per day where as gamma is directly proportional to
change in the price of the underlying
Now when there is a big move in the price of the underlying gamma
change is more than theta and therefore for a delta hedged portfolio with
long option and short underlying (positive gamma) position it results in a
+ cash flow
GAMMA HEDGING
GAMMA HEDGING :
Delta can protect against small changes in stock price, but for protection
against large changes in stock price gamma position should be made neutral
Gamma neutral position can be achieved by selling options when gamma
exposure is positive and buying options when gamma exposure is negative
For example: A stocks spot price is Rs 50 and an investor wants create a
spread and he also wants to keep his delta as well as gamma position
neutral
In order to establish delta as well as gamma neutral position, first gamma
position should be neutralized and then delta can be neutralized by taking
an offsetting position in the underlying security or futures
First the two gammas should be divided
Here gamma neutral ratio = 005/0025 = 2:1
So, if one wants to buy one June 50 call option, he should sell 2 gamma
options to make gamma neutral portfolio
Here we can see that after using the gamma neutral ratio, the spread is
gamma neutralized but delta position is still long by 10 shares Hence we
should take short position in stock by 10 shares to make delta neutral position
GAMMA HEDGING
VEGA
VEGA
Vega is also known as kappa, omega, tau
Vega is the rate of change of the value of the portfolio with respect to the
change in volatility
A vega of 012 indicates that an options value will increase/decrease by Re
012 with every 1% increase/decrease in volatility
VOLATILITY
Volatility is one of the key inputs to an option pricing model
Volatility is the degree to which the price of an underlying asset tends to
fluctuate over time
More generally, it is a measure of how uncertain we are about future stock
price movements
If an underlying asset has a small volatility or price variability, then an
option on that asset would not have much value to the holder
Types of Volatility
Future or projected volatility
is based on the expected future distribution of prices for a particular
underlying asset
Implied volatility
is calculated based on the option price traded in the marketplace It is the
volatility which would have to be input into a theoretical pricing model in
order to yield a theoretical value equal to the market value of the option
Historical volatility
is calculated based on a range of historical prices At lease 20 observations
are usually desirable to ensure statistical significance
Seasonal volatility
comes into affect with certain commodities, for example as a
consequence of changes in weather conditions or demand
UNDERSTANDING VOLATILITY
The volatility of a stock is measured by our uncertainity about the returns
provided by a stock
Typical volatilities of the stocks are in the range of 20% to 40% per annum
B&S model assumes a continuous framework and therefor while
computing returns we use: ln{[s(t+1)]/[st]}
We take these observations for 2024 previous trading days typically to
estimate historical volatilty of the daily returns from the underlying
These returns are then annualised by multiplying by sqrt(252) iE multipied
by app Number of trading days in a year to get an annualise number
This annualisd number is then plugged in the b&s model to estimate
theoritical value of the options
IMPLIED VOLATILITY
Volatility that forces the value obtained from an option pricing model
(b&s) to equal the current market price of the option
The model is said to imply the level of volatility in the underlying asset and
thereby reveal to the market , what investors expect the volatility of the
asset to be over the remaining life of the option
It can also looked upon as the consensus volatility among the market
participants
It can be much more uselful in quoting optin prices, because regardless of
the underlying price, time to expiration, or whether the option is put/call,
iv is suppose to be of the underlying asset
Sometimes option prices can reflect information about the fundamental
value of the underlying that is not immediately reflected in the price of
the stock itself, implying that the actual stock prices tend to move in the
direction iimplied by the option prices
Characteristics of Vega
Vega of long positions (ie long calls and long puts) is positive
Vega of short positions (ie short calls and short puts)is negative
The vega of underlying security is zero
Vega of atthemoney options is generally the largest
Vega decreases as an option goes further in or outofthemoney
Longterm options have higher vega than shortterm options
Variation of Vega of a Call Option
The figure below shows the variation
of vega of a call option with the stock
price
For this assume
Strike price = Rs 115,
volatility = 60 %,
rate of interest = 10% and
time to maturity = 3 months
0.0700
0.0900
0.1100
0.1300
0.1500
0.1700
0.1900
0.2100
0.2300
75 86 97 108 119 130 141 152 163 174 185
Stock Price
V
e
g
a
Variaton of vega of a call option with stock price
The figure below shows the variation of vega of options of different time to
expiry with the stock price
The figure below shows the variation of vega of options of different time to
expiry with the stock price
VEGA RISK
THE VEGA OF BOTH THE CALL AND PUT OPTIONS IS EQUAL AND POSITIVE REFLECTING THE
FACT THAT AN OPTION PRICE IS DIRECTLY RELATED TO VOLATILITY
B&S MODEL IS ACTUALLY INCONSISTENT WITH CHANGING VOLATLITY THE MODEL ASSUMES
THAT VOLATILITY WILL REMAIN CONSTANT FOR THE FULL LIFE OF THE OPTION
VEGA INVREASES WITH THE INCREASE IN TIME TO MATURITY
ATM OPTIONS ARE MOST SENSITIVE TO TOTAL POINTS CHANGE IN VOLATILITY , WHERE AS
OTM IN PERCENTAGE TERMS
VEGA OF AN ATM IS CONSTANT AT VARIOUS VOLATILITY LEVELS AND VEGA OF AN ITM OR
OTM OPTION INCREASES WITH THE INCREASE IN VOLATILITY
Theta
The Theta of a portfolio of derivatives is the rate of change of the value
of the portfolio with respect to time with all else remaining the same. It
is sometimes referred to as the time decay of the portfolio
theta = change in the value of the portfolio
change in time
Theta is always negative (positive) for the buyer (seller) of option, as
the value of option loses value each day if the anticipated view is not
realized
Example
Theta of one month Reliance 420 call option is 1
Spot =2000
Call Premium = 150
One day passes, the value for RIL 2000 call option will reduce by
Re 1/
THETA RISK
Sensitivity of Theta
A long option position will always have a negative theta and a
short option position a positive theta
The theta of an ATM option increases as expiration approaches.
This implies that a short term option will decay more quickly than
a long term option
As we increase volatility the theta of all options increases
Higher volatility means that there is a greater risk premium with
the option and each days decay will also be greater when no
movement occurs
THETA VS TIME TO MAT
0.000
2.000
4.000
6.000
8.000
10.000
12.000
14.000
16.000
18.000
20.000
0.010 0.050 0.100 0.150 0.200 0.250 0.300 0.350 0.400 0.450 0.500
Time to Maturity
t
h
e
t
a
THETA VS EXPATM
THETA VS EXP INM
THETA VS EXP OTM
Normally investors do not concentrate on theta of an individual option They
are more concerned with delta and gamma However position theta can be
calculated for an entire portfolio and an investor can get idea about the daily
gain or loss in the portfolio due to time erosion
For example: Assume an investor has following positions in the month of
June of a company named XYZ The spot price of XYZ is Rs 49
This position is expected to make a gain of Rs 456 per day due to time
decay
A negative position theta means the position has risk due to time, while a
positive position theta means time is working in favour of the position
Rho
The Rho of a portfolio of derivatives is the rate of change of
the value of the portfolio to the interest rate. It is a measure of
the sensitivity of the portfolio's value to interest rates
rho = change in the value of the portfolio
change in interest rates
Interest rates are almost constant over the expiry hence are
considered insignificant
LONG CALL
150
100
50
0
50
100
150
200
1,000 1,100 1,200 1,250 1,350 1,450 1,550
SHORT CALL
250
200
150
100
50
0
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100
150
200
1,000 1,100 1,200 1,250 1,350 1,450 1,550
LONG PUT
150
100
50
0
50
100
150
200
950 1050 1150 1250 1350 1450 1550
SHORT PUT
250
200
150
100
50
0
50
100
150
200
950 1050 1150 1250 1350 1450 1550
Option Greeks
Effect of Changing Market Conditions
Rise
Long Straddle
It involves selling a call and a put option with
same exercise price and date of expiration
Example:
STRADDLE  Pay off
300
200
100
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200
300
400
500
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SPOT
P
A
Y

O
F
F
PayOff
It involves selling a call and a put option with
same exercise price and date of expiration
Example:
Short Straddle
SHORT STRADDLE
400
300
200
100
0
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400
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F
F
PayOff
Synthetics
Synthetic pricing
Synthetic Call price
(Put Price + Stock price + CoC) Strike price
Synthetic Put price
(Call Price + Strike price  CoC) Stock price
Synthetic Stock price
(call Price  Put price) + Strike price
Note : CoC = strike price * Interest Rate * days to Expire/365
Example: Actual vs. Synthetic
All factors relevant to this particular situation:
Original stock purchase: 1000 shares of XYZ for 68
Original put purchase: Long 10 February 65 puts for 1.60
Current stock price: 69.70
Current put bid price: 1.05
Current Feb 65 call price: 6.10
Days to Exp: 30
The traders Long Rate: 2.5%
Alternative A: Sell the put and the stock at market prices
Alternative B: Close the position by treating the married put as a call;
selling the actual call against it.
Choosing Alternative A
1.70 (stock profit)  .55 (put loss) = 1.15 x 1000 = $ 1150 profit
Choosing Alternative B
The position is equivalent to a long call purchased for 4.73;calculated as
follows:
1. Cost of carry:
Interest Rate x Strike Price x Days to Expiration / 360
2.5% x 65 x 30 / 365 = .13
2. The synthetic call price
(Put Price + Stock Price + Cost to Carry)  Strike Price
(1.60 + 68 + .13)  65 = 4.73
3. Selling the actual to close out the synthetic
6.10 (actual call) 4.73 (synthetic call) = 1.37 x 1000 =$1370 profit
4. Conclusion:
Alternative B is more profitable by $220.
3. Selling the actual to close out the synthetic
6.10 (actual call) . 4.73 (synthetic call) = 1.37 x 1000 =$1370 profit
4. Conclusion:
Alternative B
is more profitable by $220.
Delta
Volatility
ITM strike
delta of higher volatility stock < delta of lower volatility stock delta
OTM strike
delta of higher volatility stock delta > delta of lower volatility stock
Delta
Time
ITM strike
delta for higher TtE stock < delta for lower TtE stock
OTM strike
delta for higher TtE stock > delta for lower TtE stock
Gamma
Volatility
ITM strike
gamma for higher volatility stock < gamma for lower volatility stock
OTM strike
gamma for higher volatility stock > gamma for lower volatility stock
Gamma
Time
ITM strike
gamma for higher TtE stock < gamma for lower TtE stock
OTM strike
gamma for higher TtE stock > gamma for lower TtE stock
THANK YOU
Black and Scholes Model
Assumptions of the Model
Stock pays no dividend during options life
European exercise terms are used
Markets are efficient i.e no arbitrage opportunity
No commissions are charged
Interest rates are constant and known
Volatility is constant
Probability and Normal distribution
Price Range Profit range Probability of
occurrences
Contribution to
expectation of
profit
150010 010 0.19 5*.19=0.95
151020 1020 0.15 2.25
152030 2030 0.09 2.25
153040 3040 0.05 1.75
154050 4050 0.01 0.45
155060 5060 0.01 0.45
Total = 0.50 Total = 8.20
Black and Scholes Model for Option
Valuation
The BS model is as follows:
where
C
0
= the current value of call option
S
0
= the current market value of the share
E = the exercise price
e = 2.7183, the exponential constant
r
f
= the riskfree rate of interest
t = the time to expiration (in years)
N(d
1
) = the cumulative normal probability density function
0 0 1 2
( ) ( )
f
r t
C S N d Ee N d
where
ln = the natural logarithm;
= the standard deviation;
2
= variance of the continuously compounded annual return on the share.
2
1
2 1
ln( / ) / 2
f
S E r t
d
t
d d t
Stock price 12 months from expiration of contract is 100, the exercise
price of option is 100. Risk free interest rate is 12% and volatility is 10%
pa.
S = 100, E=100, r=0.12, =0.1, t=1 year
d1 = IN (100/100)+(0.12 *1) + 0.5 (.10)*sqrt(1)
0.1 * sqrt(1)
= 1.25
d2 = d1 * sqrt(t)
= 1.25 (0.1)( 1)
=1.15
N (d1) = N(1.25)
= 0.8944
N (d2) = N(1.15)
= 0.8749
= 100(0.8944) 100^(0 .12*1) * 0.8749
= 11.84
0 0 1 2
( ) ( )
f
r t
C S N d Ee N d