INTRODUCTION TO

SENSITIVITY OF OPTION
PREMIUMS

Black- Scholes Model

In 1970, The Black-Scholes model was proposed by Fischer Black and
Myron Scholes by deriving a differential equation that must be satisfied
by the price of any option on a non dividend paying stock.
It is first ever close form of solution for pricing the European calls.
Prof. Scholes and Prof. Merton were awarded Nobel Prize for their
contribution in option pricing
The concept underlying Black-Scholes model is to establish no
arbitrage portfolio to value option, when stock prices are binomial.
A risk-free portfolio consisting of a position in this option and position in
the underlying stock is constructed.

Assumptions of Black- Scholes

Model
1) The stock pays no dividend during the options life this seems a
limitation to the model considering the observation that higher
dividend yield elicit lower call premiums.
2) Markets are efficient- suggests that people can not consistently
predict the direction of the market or of an individual stock.The
market operates continuously with share prices.
3) There are no transaction costs or taxes this can distort the output
of the model.
4) Interest rates remain constant and known risk free rate
5) Stock Prices are log normally distributed and European exercise
terms are used

The Black-Scholes
Formulas
c S 0 N (d1 ) K e

rT

N (d 2 )

p K e rT N (d 2 ) S 0 N (d1 )
2
ln(S 0 / K ) (r / 2)T
where d1
T
ln(S 0 / K ) (r 2 / 2)T
d2
d1 T
T

The model

The model
The values of d1 and d2 are in units of volatility
N(x) is the cumulative probability distribution function for a
variable that is normally distributed with a mean of 0 and a
standard deviation of 1.
While calculating the values you should remember that N(d) =1N(-d).
N(d1) can be interpreted as the probability of the call option
being in-the money at expiry.
SN(d1) derives the expected benefit from acquiring a stock
outright
Xe^-r(T-t)gives the present value of paying the exercise price on
the expiration day.

Introduction to Greeks

Options Greeks refers to what analysts use to

predict options prices

Option Greeks are the mathematical

characteristics which are used within the
Black-Scholes model for pricing options
premiums.

These mathematical characteristics are

named after the Greek letters which are used
to represent them when used in equations.

The Option Greeks are the quantities

representing the sensitivities of derivatives
such as options to a change in underlying
parameters on which the value of an
instrument or portfolio of financial instruments
is dependent.

The Option Greeks are a series of values that

gives the investor a better overall view of how
a stock has been performing. These values can
be helpful in deciding what options strategies
are best to use.

Importance of Option
Greeks

Setting Expectations

Selecting Strike Prices

Selecting Expirations

Managing Position Risk

Use of Option Greeks

Option Greeks are used to allow option

traders the chance to calculate the
changes in the value of their option
contracts that are in their portfolio in an
objective way against the changes in all of
the factors which affect stock option
values.
It gives the trader an option to hedge his
potfolio
Measurement of risk

Sensitivity Analysis

The Sensitivity analysis of option

premium deals with the measurement of
changes in option price due to the
change in the underlying parameters
that determine the option prices. These
parameters include stock price, time
period, interest rate and Volatility.

Sensitivity Analysis

Most people believe that the price of an

option has a one to one relationship with
a stock.
There are many factors that come into
consideration while determining the
price of an option
These factors are given to use through
the Greeks

Delta (Greek Symbol ) - a measure of an options

sensitivity to changes in the price of the underlying asset

Gamma (Greek Symbol ) - a measure of deltas sensitivity

to changes in the price of the underlying asset

Vega - a measure of an options sensitivity to changes in

the volatility of the underlying asset

Theta (Greek Symbol ) - a measure of an options

sensitivity to time decay

Rho (Greek Symbol ) - a measure of an options sensitivity

to changes in the risk free interest rate

Delta
Consider a hypothetical portfolio whose value
depends upon some underlier whose current value
is USD

Example : Portfolio Value as a Function

of Underlier Value

What does the graph

indicate ?

Relationship between portfolio's current

market value and the underlier.
Assumption : other market variables are
unchanged.
Portfolio value will increase if the
underlier increases, and it will decrease
if the underlier decreases.
This is what Delta communicates along
with the magnitude of such sensitivity.

Lets fit a tangent line to the

curve in the above diagram

Delta is the Slope of the

Tangent Line

In the above example the slope of the

tangent line is 0.8
This indicates for each unit increase in
the underlier, the portfolio's price
appreciates by 0.8 times.
Hence portfolio's delta is 0.8

What Delta is ?

Delta () measures the rate of change of option

value with respect to changes in the underlying
asset's price.
Delta is the first partial derivative of a portfolio's
valuewith respect to the valueof the underlier.
Delta is represented as follows :

Where is a S is a small change in the underlier's

current value and V is the corresponding change
in the portfolio's current value.
Delta approximation

Relationship between call

and put delta

The sum of the absolute values of the delta of

each option will be 1.00 provided it has :
Same strike price
Same underlying asset
Same maturity
If the delta of a call is .42 then one can compute
the delta of the corresponding put at the same
strike price by 0.42 - 1 = -0.58

Practical use

Call deltas are positive; put deltas are negative

Delta is a number between 0.0 and 1.0 for a call
and 0.0 and -1.0 for a put
The delta of underlying asset is always 1.0
Commonly presented as a percentage of the total
number of shares represented by the option
contract(s).
For Example, if an American call option on XYZ
has a delta of 0.25, it will gain or lose value just
like 25% of 100 shares or 25 shares of XYZ as the
price changes for small price movements.

As a proxy for
probability

Traders use the absolute value of delta as the

probability that the option will expirein-the-money
If anout-of-the-moneycall option has a delta of
0.15, the trader might estimate that the option has
appropriately a 15% chance of expiring in-themoney.
If a put contract has a delta of -0.25, the trader
might expect the option to have a 25% probability
of expiring in-the-money.
At-the-moneyputs and calls have a delta of
approximately 0.5 and -0.5 respectively

Option Greeks
23

What happens to option price when one input

changes?
Delta (): change in option price when stock price
increases by Re.1
Gamma (): change in delta when option price
increases by Re.1
Vega: change in option price when volatility
increases by 1%
Theta (): change in option price when time to
maturity decreases by 1 day
Rho (): change in option price when interest rate
increases by 1%