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CONTENTS

1. What are Greeks?

2. Types of Greeks

A Greek measures a certain dimension /

aspect of risk involved in an option position

There are various Greeks

Different Greeks measure different aspects

of risk involved in an option position

(different types of risk)

A trader intends to manage all the Greeks

so as to neutralise them (reduce their

impact to zero) / to hold the risks to an

acceptable level

Why / How do these risks arise?

The value of an option changes when

some fundamental factors change

These fundamental factors are:

o Asset Price

o Time to Expiration

o Volatility of the Asset &

o Interest Rate

2. Types of Greeks

Each fundamental factor affecting the

value of an option is represented by a

Greek. Each Greek measures the

influence of a factor on the value of the

option. They are:

A. Delta

B. Theta

C. Gamma

D. Vega

E. Rho

2A. Delta

It is the rate of change of the option

price wrt the price of the underlying

asset

It is the Slope of the curve that

relates option price to the price of

underlying asset

For a European call option on a nondividend paying stock, Delta is +ve

For a European put option Delta is

-ve

2A. Delta

An investor can take either a long or a

short position in the Call / Put options

So delta of an Option has to be

distinguished from delta of a Position

(long / short) in the option

Typically for any Option (Call / Put):

Delta of a Long position has the same

sign as the delta of the option

Delta of a Short position has the opposite

sign to that of the delta of the option

2A. Delta

Delta of Call is +ve. So a long position on

the Call will have +ve delta whereas

short position in the same call will have

ve delta

Delta of Put is ve. So a long position on

the Put will have ve delta whereas short

position in the same Put will have +ve

delta

2A. Delta

By holding appropriate combination of

stock & option the delta of the overall

position can be neutralised

Neutralising the delta means reducing the

delta of the overall position to Zero

This means: the change in value of the

overall position will be equal to Zero

This is called Delta Hedging

Hedging

Positive Delta implies that the price of option

increases with an increase in asset price & vice versa

Negative Delta implies that the price of option

decreases with an increase in asset price & vice

versa

If an option has Positive Delta then the position in

asset to be taken for hedging should be opposite to

the position in the option

If an option has Negative Delta then the position in

asset to be taken for hedging should be same as the

position in the option

2A. Delta

A call option has a +ve delta. So the

call price increases with an increase in

stock price & decreases with a

decrease in stock price

Hence:

A long position in a call should be

hedged by short position in stock

A short position in a call should be

hedged by a long position in stock

2A. Delta

A put a option has a ve delta. So the

price of put decreases with an increase in

stock price & vice versa

Hence:

A long position in a put should be hedged

by a long position in the underlying stock

A short position in a put should be

hedged by a short position in the

underlying stock

2A. Delta

Eg 1: Consider a European call option

on a stock which has a delta of

0.522. What is the implication of this

value?

2A. Delta

Ans-1:

The delta of 0.522 indicates that when the stock

price increases by Re.1, the call price increases by:

Rs. 0.522

Similarly when the stock price decreases by Re.1 the

call price decreases by: Re. 0.522

So a long position of 1 call option should be hedged

by a short position in 0.522 shares

A short position of 1 call option should be hedged by

a long position in 0.522 shares

The objective is to hold positions in the option &

stock so that the total change in the overall position

is Zero

Delta of a Portfolio of options is a function

of the delta of the individual options:

n

wi i

i 1

w i Quantity of option ' i'

required in the underlying asset to make

the portfolio delta = Zero

If such a position is taken the portfolio is

said to be delta neutral

Eg. 2: A financial institution has the following

positions in options on a stock:

1. Long position in 100000 call options with strike

55 & 3 months to expiry; delta of each option:

0.533

2. Short position in 200000 call options with strike

56 & 5 months to expiry; delta of each option:

0.468

3. Short position in 50000 put options with strike

56 & 2 months to expiry; delta of each option:

-0.508

Calculate portfolio delta and Explain.

Ans-2: Portfolio Delta = 100000 x 0.533 200000

x 0.468 50000 x (-0.508) = -14900

This means when the stock price increases by

Re. 1 the portfolio value will decrease by Rs.

14900

We have to take a position in the stock such that

the overall change in the portfolio value is Zero.

So the portfolio can be made Delta Neutral by

buying 14900 shares (long position in 14900

shares)

In order to minimise transaction costs

dealers rebalance their positions once a

day to maintain delta neutrality

If no. of options in portfolio is less then

rebalancing will be expensive

Rebalancing means buying / selling the

required no. of shares to neutralise the

portfolio delta

Given the delta of portfolio only one

transaction in the underlying asset in a day

is required to neutralise the portfolio delta

2B: Theta

Theta () of an option is the rate of change of

the value of the option with the passage of

time, other things remaining the same

Also referred to as Time Decay of option

Theta is generally expressed with reference

to days

When expressed with reference to days it

indicates the change in portfolio value when 1

day passes, other things remaining the same.

2C: Gamma

Gamma of an option on an underlying asset is

the rate of change of its delta with reference

to the price of the underlying asset

If absolute value of gamma is small delta

changes slowly with change in the price of the

underlying asset so adjustments to make the

portfolio delta neutral need to be made only

infrequently

If it is large then delta is highly sensitive to

the price of underlying asset so the

rebalancing has to be done very frequently in

order to maintain delta neutrality of portfolio

Aspects

The equation for gamma shows the change

in the portfolio value that will occur if the

price of the underlying asset changes by a

small amount S during a small interval of

time t for a delta neutral portfolio

A position in the underlying asset has Zero

gamma & cannot be used to change the

gamma of portfolio

In order to change the gamma of a portfolio

a position in the option contract itself has

to be taken

2C: Gamma

By taking a position in a traded option on the

underlying asset, gamma of portfolio can be

neutralised BUT including the option position

will also change the delta of the portfolio.

This will further require neutralising the delta

of portfolio by taking a position on the

underlying asset

So making a portfolio gamma neutral

requires that the delta neutrality of the

combined position be maintained at the

same time

2C: Gamma

Eg. 3: A delta-neutral portfolio has a

gamma of:

-3000. The delta & gamma of a traded

call option are 0.62 & 1.5 respectively.

How can we make the portfolio gamma

neutral?

2C: Gamma

Ans. 3: Making the portfolio gamma neutral means

combining the portfolio with a certain no. of the

options so that the gamma of the combined

position becomes zero.

Gamma of combined position = Gamma of portfolio

+ No. of call options x Gamma of each call option

= -3000 + N x 1.5 (N is no. of call options)

Gamma of combined position should be = 0. Thus

-3000 + N x 1.5 = 0 or N = 3000/1.5 = 2000

This means the portfolio can be made gamma

neutral by taking long position in 2000 call options

But taking a long position in 2000 call options

will disturb the delta of the combined position.

So a position in the underlying asset has to be

taken to neutralise the delta.

Delta of the combined position after taking

long position in 2000 call options = Delta of

Original Portfolio + Delta of 2000 call options

purchased =

0 + 2000 x 0.62 = 1240

This means 1240 units of the underlying asset

must be sold / shorted to make the combined

position delta neutral

2D: Vega (v )

Vega represents the change in the value

of an option due to changes in the

volatility of the underlying asset

It is the rate of change of the value of the

option with respect to the volatility of the

underlying asset

If the absolute value of Vega is high the

portfolios value is very sensitive to small

changes in volatility

A position in the underlying asset has Zero

Vega

2D: Vega (v )

Vega of a portfolio of options can be

changed by adding a position in a traded

option

A portfolio that is Gamma neutral will

NOT be Vega neutral & vice versa

Being Vega neutral means that the Vega

is zero

2E: Rho

Rho of an option is the rate of change of

the value of the option with reference to

interest rate

It measures the sensitivity of the value of

the option to a change in interest rate,

other things remaining same

2E: Rho

Eg. 4: The rho of a call option on a nondividend paying stock is 8.91.

Interpret this.

2E: Rho

Ans. 4: This means:

An increase in interest rate causes an

increase in the value of the option

(because rho is +ve)

1% increase in interest rate means an

increase in interest rate by 0.01

Rho = 8.91 implies that an increase of

0.01 in the interest rate will cause an

increase of: 0.01 x 8.91 = 0.0891 in the

value of the call option

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