FINANCIAL ENGINEERING
Option Greeks and Trading Volatility
by Dr. Aditya Sharma
Motivation underneath Option trade
• An option is an instrument with directional as well as volatility as its
underpinning
• How does an investor see an option?
• Whether to buy call or put option?
• How does a trader see an option?
• Whether to buy call or put option?
Motivation underneath Option trade
• An option trader becomes interested in long volatility positions,
especially around the earnings announcement as the market
sentiment is particularly negative during the period.
• Worse-than-expected earnings releases from one company can
send shockwaves through the entire market suddenly making
the market more volatile.
EX: One promising name . . . Announced in mid-February that manufacturing process and
control issues have led to reduced sales of certain products in the US, which is expected to
influence its first quarter and full-year sales and earnings.
On Friday, options maturing in August had a mid-market implied vol of around 43%, which
implies a 2.75% move in the stock per trading day. Over the last month, the stock has been
moving an average of 3% a day, which means that by buying options on the company, you’re
getting vol cheap.
Motivation underneath Option trade
• Three important characteristics of options from a trader`s
point of view
1. For traders Puts and Calls are virtually the same instruments
2. The amount of volatility is important and not the direction of movement for
the traders
3. The large movements in the underlying stock price lead to Gamma gains and
the implied volatility changes lead to Vega gains
Option Moneyness
Option Moneyness
Option Moneyness
Option Notations
• Call option pricing function can be seen as
• The function can have the following partial derivatives
Option Value and Payoff
Option Value and Payoff
Option Example
• Suppose Microsoft (MSFT) is “currently” trading at 61.15 at Nasdaq. Further, the overnight rate is
2.7%. We have the following quotes from the Chicago Board of Options Exchange (CBOE).
• In the table, the first column gives the expiration date and the strike level of the option. The exact
time of expiration is the third Friday of every month. These equity options in CBOE are of
American style. The bid price is the price at which the market maker is willing to buy this option
from the client, whereas the ask price is the price at which he or she is willing to sell it to the
client.
Option Greeks
Example
• A bank has sold for $300,000 a European call
option on 100,000 shares of a non-dividend
paying stock
• S0 = 49, K = 50, r = 5%, s = 20%,
T = 20 weeks, m = 13%
Option Greeks
Example
• The Black-Scholes-Merton value of the option is
$240,000
• How does the bank hedge its risk to lock in a
$60,000 profit?
Naked & Covered Positions
• Naked position
• Take no action
• Covered position
• Buy 100,000 shares today
• What are the risks associated with these
strategies?
Stop-Loss Strategy
• This involves:
• Buying 100,000 shares as soon as price reaches
$50
• Selling 100,000 shares as soon as price falls
below $50
Stop-Loss Strategy continued
Ignoring discounting, the cost of writing and hedging the option
appears to be max(S0−K, 0). What are we overlooking?
Greek Letters
• Greek letters are the partial derivatives with
respect to the model parameters that are liable to
change
• Usually traders use the Black-Scholes-Merton
model when calculating partial derivatives
• The volatility parameter in BSM is set equal to the
implied volatility when Greek letters are
calculated. This is referred to as using the
“practitioner Black-Scholes” model
Delta
• Delta (D) is the rate of change of the option
price with respect to the underlying asset price
Call option
price
Slope = D = 0.6
B
A Stock price
Hedge
• Trader would be hedged with the position:
• short 1000 options
• buy 600 shares
• Gain/loss on the option position is offset by loss/gain on stock
position
• Delta changes as stock price changes and time passes
• Hedge position must therefore be rebalanced
Delta Hedging
• This involves maintaining a delta neutral portfolio
• The delta of a European call on a non-dividend paying stock is N (d 1)
• The delta of a European put on the stock is
N (d 1) – 1
For dividend paying stocks the delta are
Delta of a Stock Option (K=50, r=0, s = 25%, T=2)
Call Put
Variation of Delta with Time to
Maturity(S =50, r=0, s=25%)
0
The Costs in Delta Hedging
continued
• Delta hedging a written option involves a “buy
high, sell low” trading rule
First Scenario for the Example:
Week Stock Delta Shares Cost Cumulative Interest
price purchased (‘$000) Cost ($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
....... ....... ....... ....... ....... ....... .......
19 55.87 1.000 1,000 55.9 5,258.2 5.1
20 57.25 1.000 0 0 5263.3
Second Scenario for the Example Table
19.3, page 405
Week Stock Delta Shares Cost Cumulative Interest
price purchased (‘$000) Cost ($000)
0 49.00 0.522 52,200 2,557.8 2,557.8 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
....... ....... ....... ....... ....... ....... .......
19 46.63 0.007 (17,600) (820.7) 290.0 0.3
20 48.12 0.000 (700) (33.7) 256.6
Theta
Theta (Q) of a derivative (or portfolio of
derivatives) is the rate of change of the
value with respect to the passage of time
The theta of a call or put is usually
negative. This means that, if time passes
with the price of the underlying asset and
its volatility remaining the same, the value
of a long call or put option declines
Theta for Call Option (K=50, s = 25%, r = 0, T = 2)
0 20 40 60 80 100 120 140
0
Stock Price
-0.5
-1
-1.5
-2
-2.5
Variation of Theta with Time to
Maturity (S =50, r=0, s=25%)
0
Theta
𝑆𝑜 𝑁′ 𝑑1 𝜎
ϴ= − − 𝑟𝐾𝑒 −𝑟𝑇 𝑁(𝑑2 )
2 𝑇
2
−𝑑1 ൗ
1
Where, 𝑁 ′ 𝑑1 = 𝑒 2
2𝜋
Gamma
• Gamma (G) is the rate of change of delta
(D) with respect to the price of the
underlying asset
• Gamma is greatest for options that are
close to the money
Gamma Addresses Delta Hedging Errors
Caused By Curvature
Call
price
C''
C'
C
Stock price
S S'
Interpretation of Gamma
For a delta neutral portfolio, DP Q Dt + ½GDS 2
DP DP
DS
DS
Positive Gamma Negative Gamma
Gamma for Call or Put Option: (K=50, s = 25%, r = 0%, T = 2)
Variation of Gamma with Time to Maturity
(S0=50, r=0, s=25%)
Relationship Between Delta, Gamma, and
Theta
For a portfolio of derivatives on a stock
paying a continuous dividend yield at
rate q it follows from the Black-Scholes-
Merton differential equation that
1 2 2
Q rSD s S G = rP
2
Vega
• Vega (n) is the rate of change of the value of
a derivatives portfolio with respect to volatility
• If vega is calculated for a portfolio as a
weighted average of the vegas for the
individual transactions comprising the
portfolio, the result shows the effect of all
implied volatilities changing by the same
small amount
Vega for Call or Put Option (K=50, s = 25%, r = 0, T = 2)
Taylor Series Expansion
• The value of a portfolio of derivatives dependent on an asset is a
function of of the asset price S, its volatility s, and time t
P P P 1 2P
DP = DS Ds Dt DS
2
S s t 2 S 2
= Delta DS Vega Ds Theta Dt Gamma DS
1 2
2
Managing Delta, Gamma, & Vega
• Delta can be changed by taking a position in the underlying
asset
• To adjust gamma and vega it is necessary to take a position in
an option or other derivative
Example
Delta Gamma Vega
Portfolio 0 −5000 −8000
Option 1 0.6 0.5 2.0
Option 2 0.5 0.8 1.2
What position in option 1 and the underlying asset will
make the portfolio delta and gamma neutral? Answer:
Long 10,000 options, short 6000 of the asset
What position in option 1 and the underlying asset will
make the portfolio delta and vega neutral? Answer: Long
4000 options, short 2400 of the asset
Example continued
Delta Gamma Vega
Portfolio 0 −5000 −8000
Option 1 0.6 0.5 2.0
Option 2 0.5 0.8 1.2
What position in option 1, option 2, and the asset will make the portfolio
delta, gamma, and vega neutral?
We solve
−5000+0.5w1 +0.8w2 =0
−8000+2.0w1 +1.2w2 =0
to get w1 = 400 and w2 = 6000. We require long positions of 400 and 6000
in option 1 and option 2. A short position of 3240 in the asset is then
required to make the portfolio delta neutral