The Greeks

The Greeks
Option pricing models value options taking as given
information about five inputs - price of underlying, Strike
price, risk-free rate, volatility, time to expiration, at a
point in time.
With changes in the values of these factors the Options
price will also change.
Sensitivity Analysis aims to quantify the impact of a
change in each factor on the option price.
Corresponding to these factor is a sensitivity measure
(called the option Greeks) that gives the quantitative
impact of a change in that factor on the option price.
2

The Greeks
The five sensitivity measures or Greeks are:
1. Delta () : Measures impact of a "small" change in
asset price on option price.
2. Gamma () : Measures option curvature, and can be
used to estimate impact of a "large" change in asset
price on option price.
3. Theta () : Measures impact of passage of time on
option price.
4. Vega () : Measures impact of a change in volatility
of the underlying asset on option price.
5. Rho () : Measures impact of change in interest rate
on option price.
3

The Greeks
Base Case

Stock Price (Rs.)

Exercise Price (Rs.)
Time to Maturity (Years)
Risk-free rate (%)
Volatility (%)

100.00
100.00
0.50
5.00%
20.00%
Base Case

Price
Delta (per Rs.)
Gamma (per Rs.per Rs.)
Vega (per %)
Theta (per day)
Rho (per %)

6.889
0.598
0.0274
0.27359
-0.022
0.26442

Call Price

Call Option price curve

24
22
20
18
16
14
12
10
8
6
4
2
0
65

70

75

80

85

90

95

100 105 110 115 120 125

Stock Price

Option Delta
Delta () is single most important sensitivity measure
for an option.
Measures the sensitivity of option values to changes in
the price of the underlying asset.
Delta is the change in option value per Rs. 1 change in S.
Intuitively, the delta may be thought of as a ratio:
C

C
S

P
S

Delta is defined as the slope of the option price curve.

As a sensitivity measure Delta is typically very accurate
for "small" changes in S.
6

Properties of Option Delta

1. As call price increases when the price of the underlying
increases, delta of a call is always positive: C 0.
2. Put prices decrease when the price of the underlying
increases, the delta of a put is always negative: P 0.
3. Moreover, the delta of a call option is always less than
+1, as call cannot increase by more than Re1 for Re1 of
increase in price of underlying asset. C 1 and
P 1.
Thus,

0 C 1

1 P 0

Delta and Moneyness

Size of Delta depends upon the moneyness of the

option:
1. When an option is deep out-of-the-money, its value is
close to zero and not very responsive to changes in the
price of the underlying, hence such options have deltas
close to zero.
2. When an option is deep in-the-money, its value
responds almost one-for-one to changes in the price of
the underlying, such options have deltas close to one
(in absolute value).
3. In general, as an option moves from deep OTM to deep
ITM, its delta (in absolute value) moves from zero
towards one.
8

Call and Put Deltas

Calculating Delta
The delta of a call in the Black-Scholes framework is given
by the quantity N (d1), and the delta of a put by the term
N (d1):

C = N (d1)

P = N (d1)

10

Using the Option Delta

If the stock price changes by a small amount (dS ), the
estimated change in an option price is:
the option delta change in stock price.

dc = c dS

dp = p dS

Suppose the price of the underlying stock increases by

Re. 0.50. What would be impact on the Call Price?
dS = +0.50 and C = +0.598,
dC = C dS = 0.598 0.50 = 0.299
Estimated Call Price (New) = 6.889 + 0.299
= Rs. 7.188.
Call Price estimated by B-S Model: Rs. 7.191
Estimated and actual values (BSMOPM)differ slightly.
11

Delta
Stock Price (Rs.)
Exercise Price (Rs.)
Time to Maturity (Years)
Risk-free rate (%)
Volatility (%)
Price
Delta (per Rs)
Gamma (per Rs per Rs)
Vega (per %)
Theta (per day)
Rho (per %)

Base Case
100.00
100.00
0.5
5.00%
20.00%

Case 1
100.50
100.00
0.5
5.00%
20.00%

6.8887
0.5977
0.0274
0.27359
-0.0222
0.26442

7.1910
0.6113
0.0270
0.27239
-0.0224
0.27123
12

How good is the Estimate?

In general, these estimates do very well for "small" dS.
However, they become progressively less accurate as dS
increases.
Suppose the price of the underlying stock increases by
Rs. 5/-. What would be impact on the Call Price?
dS = +5.00 and C = +0.598,
dC = C dS = 0.598 5 = 2.990
Estimated Call Price (New) = 6.889 + 2.990
= Rs. 9.879
Call Price estimated by B-S Model: Rs. 10.201
13

The Delta Approximation Error

New Stock Price New Call Price Delta Approximation Difference
95
4.255
3.900
0.354
96
4.723
4.498
0.226
97
5.222
5.096
0.126
98
5.749
5.693
0.056
99
6.305
6.291
0.014
100
6.889
6.889
0.000
101
7.500
7.486
0.014
102
8.138
8.084
0.054
103
8.801
8.682
0.119
104
9.489
9.280
0.210
105
10.201
9.877
0.324

The delta underestimates the change in Call Prices.

14

Source of the error

Curvature in the option price:
the option price is not linear in S
When we use dC = C dS, an
implicit assumption of linearity
is made.
The smaller the curvature, the
more accurate is delta as a
measure of option risk (for deep
OTM and ITM options).
The option gamma is used to
quantify and account for this
curvature in measuring option
sensitivity.
15

Option Gamma
Gamma measures the curvature of the option pricing
function.
Curvature is the change in the slope of a function.
Since the slope is measured by the delta, gamma is the
rate of change of the delta.
Gamma () = Change in Option Delta per Rs.1 change in S

d C d2C
Gamma
2
dS dS

d P d P
Gamma
2
dS dS
2

16

Sign of Option Gamma

Call and put deltas both increase as S increases.
This means the gammas of both puts and calls are
positive.

17

Gamma and Moneyness

For both calls and puts, the option delta is:
0 and insensitive to changes in S, if option is deep
OTM.
1 in absolute value and insensitive to changes in S
if option is deep ITM.
Responds rapidly to changes in S if option is at- or
near-the-money.
Thus, the gamma is:
least when the option is deep OTM or deep ITM.
is highest when the option is at- or near-the-money.

18

Option Gamma

Option gamma is least for deep OTM or deep ITM

options and highest when the option is at- or near-themoney
19

Using Gamma as a Correction Factor

Consider a large change a in the stock price.
A more accurate estimation of the change is obtained
by

Improvement occurs for all a but is especially

significant for "large" a.

20

Using Gamma as a Correction Factor

Recalculate the price of Call, when the underlying stock
increases by Rs. 5/-.

a = +5.00 and C = +0.598, =0.0274

dC = (50.598) + (0.50.027425) = 2.990 + 0.3425 =3.3325
Estimated Call Price (New) = 6.889 + 3.3325 = Rs.10.2215
(vs. Rs. 9.877 as per delta approximation)
Call Price estimated by B-S Model: Rs. 10.201

Although using gamma correction provides a better

approximation than the delta approximation
It is still an approximation.
21

Delta-Hedged Portfolios & Price Changes

Gamma of an option is always +ve.
Holder of an option is said to be long on Gamma, while
option writer is short on Gamma.
Delta-hedging involves offsetting the risk in the written
options position by using a position in the underlying.
Options have a curvature while stock pay-offs are linear.
(i.e. have zero gamma)

22

Delta-Hedged Portfolios & Price Changes

Consider you are short on call and have delta hedged
yourself by holding units of the stock.
Suppose the stock price registers an unanticipated move
of a.
Change in value of stock held: a.
Change in option value: approximately
So change in portfolio value is approximately
This is negative regardless of a.
Thus, a delta-hedged position in which you are short on the
option, will lose money from a change in prices, regardless of
the direction in which the price moves.
Larger the gamma, larger will be the loss of any given a.
23

Using Gamma as a predictor of change in Delta

Gamma is the change in delta of an option.
As a measure of curvature, gamma reflects a view on
volatility.
Hence, it is a predictor of change in delta caused by
change in S.
Gamma () = Change in Option Delta / change in S
Or Change in Delta = Gamma * change in S
If S changes to 105, change in delta based on Gamma
would be:
= 0.0274*5 = 0.1370
New Delta = old delta + change in delta
= 0.5977 + 0.1370 = 0.7347.
25

Using Gamma for predicting change in Delta

Stock Price (Rs.)
Exercise Price (Rs.)
Time to Maturity (Years)
Risk-free rate (%)
Volatility (%)
Price
Delta (per Rs)
Gamma (per Rs per Rs)
Vega (per %)
Theta (per day)
Rho (per %)

Base Case
100.00
100.00
0.5
5.00%
20.00%

Case 2
105.00
100.00
0.5
5.00%
20.00%

6.8887
0.5977
0.0274
0.27359
-0.0222
0.26442

10.2013
0.7232
0.0225
0.24852
-0.0226
0.32869

26

Gamma and Hedge Rebalancing Frequency

Option gamma is used as an indicator of the frequency
with which a delta hedge needs to be rebalanced.
"Small" delta does not change much for changes in
S.
Thus, a delta hedged position will remain approximately
delta hedged even as S changes.
Large even small change in S can create a
substantial change in the delta.
Thus, a delta-hedged position may become risky
following changes in S and the hedge will have to be
rebalanced more frequently.

27

Making Portfolio Gamma neutral

Suppose a delta-neutral portfolio has a gamma = P and
another traded option has Gamma = T
If wT units of traded options are added to the existing
portfolio, then the gamma of the new portfolio would be:
wT T + P.
For the new portfolio to be Gamma neutral, this should
P
be equal to zero. i.e. wT T + P = 0
w
T

Making a portfolio gamma and delta neutral is correcting

for the hedging error.
Delta neutrality provides protection against small change
in stock prices while gamma neutrality provides
protection against large changes in stock prices.
28

Option Theta
Options are finitely-lived instruments.
Time-left-to-maturity plays a major role in determining
option values.
Option theta measures the impact of the passage of time
on option values.
P
Theta is defined by: C C
P
t

Intuitively, theta measure the change in the option

values for a small move forward in current time (i.e., for
a small reduction in the time-to-maturity).

Theta is often referred to as the time-decay in an option.

29

Option Theta
Call Theta (C ) = -

S0 e

-d12 /2

2 2T

- rf Xe-rf TN(d2 )

30

Option Theta

Theta conveys the daily cost of holding the option.

If 1-day theta is say 0.25, it means that every day the
option holder is losing Re. 0.25 in the option value.
Sign of theta (Opposite of Gamma)
Long positions : Theta is -ve
Short positions : Theta is +ve
Underlying assets (stocks) have zero theta.

31

Option Theta
Theta is the highest for ATM options and lesser for ITM
& OTM Options.
ATM Options have the highest time value, so they have
more to loose over time as compared with ITM /OTM
Options.
OTM options have the lowest Theta as they have lowest
time value.
0
-0.0175.00

95.00

115.00

135.00

155.00

175.00

-0.02
-0.03

Theta

-0.04
-0.05
-0.06
-0.07
-0.08
-0.09
-0.1

Asset Price

32

Using Option Theta

0
0.01

0.06

0.11

0.16

0.21

0.26

0.31

0.36

0.41

0.46

-0.02

Theta

-0.04

-0.06

-0.08

-0.1

-0.12

-0.14

Time to Expiry

Value of a Call decreases as time elapses

33

Using Option Theta

Option theta estimates that for a given change dt, the
change in option values is given by

dc c dt

dp p dt

If dt = 0.004 years (1 trading day), what would be the

estimated call price.
For dt = 0.004 years, the Estimated change in call
value = Theta* dt = ( - 0.0222*365)*0.004
= -8.103 *0.004 = - 0.03241
Estimated Call price = 6.8887 + (-0.03241) = 6.85629
34

Using the Option Theta

Stock Price (Rs.)
Exercise Price (Rs.)
Time to Maturity (Years)
Risk-free rate (%)
Volatility (%)
Price
Delta (per Rs)
Gamma (per Rs per Rs)
Vega (per %)
Theta (per day)
Rho (per %)

Base Case
100.00
100.00
0.5
5.00%
20.00%

Case 3
100.00
100.00
0.496
5.00%
20.00%

6.8887
0.5977
0.0274
0.27359
-0.0222
0.26442

6.8562
0.5974
0.0275
0.2726
-0.0223
0.26228
35

Option Vega
Volatility is a primary determinant of option value.
The option vega () measures the impact of a change in
volatility on option price.
Vega is defined by:
C
C

Vega measures the impact on call and put values of a

small change (d ) in current volatility.

36

Option Vega
Vega () measures an options price sensitivity wrt
Volatility.

Call Vega () =

S0 te

-d12 /2

Vega () conveys how much the option premium will

increase or decrease with increase/ decrease in the
level of volatility.

37

Option Vega
Relationship between volatility and the option price
is nearly linear.
25
20

Option P rice

15
10
5
0
5.00% 15.00% 25.00% 35.00% 45.00% 55.00% 65.00% 75.00%

Volatility

38

Option Vega
Vega of (say) 0.2454 means that the option premium
would increase by 24.54% if the volatility increases
by 1%.
Sign of Vega
Long positions (call or put) : + ve
Short positions (call or put) : - ve

39

Option Vega
Vega for calls and puts is the same
Vega is the highest for ATM options and lower for ITM
and OTM options
0.3
0.25

Vega

0.2
0.15
0.1
0.05
0
75.00

95.00

115.00

135.00

155.00

175.00

Asset Price

40

Option Vega
For European options, the vega of a call always equals
the vega of an otherwise identical put.
This follows from put-call parity: C P = S Xe-rt
Differentiating both sides with respect to , we get
c p

which says precisely that C = P.

41

Using Option Vega

Given d, vega estimates change in option prices of d
.
Formula works well for "small" d .
If d = 0.01, what would be the estimated call price.

For d = 0.01, the Estimated change in call value =

Vega* d = (27.36)*0.01 = 0.2736
Estimated Call price = 6.8887 + (0.2736) = 7.1623

42

Using the Option Vega

Stock Price (Rs.)

Exercise Price (Rs.)
Time to Maturity (Years)
Risk-free rate (%)
Volatility (%)
Price
Delta (per Rs)
Gamma (per Rs per Rs)
Vega (per %)
Theta (per day)
Rho (%)

Base Case
100.00
100.00
0.5
5.00%
20.00%

Case 4
100.00
100.00
0.5
5.00%
21.00%

6.8887
0.5977
0.0274
0.27359
-0.0222
0.26442

7.1625
0.5958
0.0261
0.2739
-0.0229
0.26211
43

Option Rho
Options are securities with deferred payoffs, so their
values are affected by the rate of interest.
The option rho ( ) measures the sensitivity of option
prices to changes in interest rates and is defined by

Rho measures the impact on call and put values of a

small change (dr) in the risk-free rate.

44

Properties of Option Rho

The sensitivity of the call price with respect to the risk free interest rate is called its Rho.
-rf t

Call Rho ( ) = tXe N(d2 )

18

Option Price

17.5
17
16.5
16
15.5
15
0.05%

2.05%

4.05%

6.05%

8.05%

10.05%

12.05% 14.05%

Risk-free Rate

A near linear relationship between option price and riskfree interest rate makes Rho a fairly accurate measure of
option price sensitivity.
45

Properties of Option Rho

The rho of a call is positive (C if r ).
The rho of a put is negative (P if r ).

46

Using the Option Rho

For a given dr, the rho estimates that option prices will
change by c dr.
Formula works well for "small" dr.
If dr = 0.0025, what would be the estimated call price.

For a 25 basis points change (dr = 0.0025), the

Estimated change in call value: (Rho * dr)
(26.44)(0.0025) = 0.0661
Estimated Call price = 6.889 +0.0661 = 6.9551.
47

Using the Option Rho

Stock Price (Rs.)
Exercise Price (Rs.)
Time to Maturity (Years)
Risk-free rate (%)
Volatility (%)
Price
Delta (per Rs)
Gamma (per Rs per Rs)
Vega (per %)
Theta (per day)
Rho (per %)

Base Case
100.00
100.00
0.5
5.00%
20.00%

Case 5
100.00
100.00
0.5
5.25%
20.00%

6.8887
0.5977
0.0274
0.27359
-0.0222
0.26442

6.9550
0.6012
0.0273
0.2730
-0.0226
0.26580
48

Portfolio (Position) Greeks

The greeks are easily extended to portfolios consisting
of options and the underlying.
The position greek is simply equal to the sum of the
greeks of each option weighted by the number of
options, plus the sensitivity of the underlying to that
parameter.
The delta of the underlying is equal to +1.
The gamma, vega, and rho of the underlying stock are
all equal to zero.
Position Delta : Directional view for the portfolio
If Position Delta is +ve: Bullish
If Position Delta is ve: Bearish
= 0 : Delta Neutral
49

Making Portfolio Delta, Gamma, & Vega neutral

Consider the following Greeks:
Security
Call A
Stock

Delta
0.60
1.00

Gamma
1.50
0.00

Vega
1.20
0.00

Call B
Call C

0.50
0.40

2.00
0.80

1.50
1.00

What would be the Delta, Gamma, & Vega of the

portfolio consisting of 100 short CallA & 60 long Stock.
How can this portfolio be made Delta, Gamma & Vega
neutral?
50

Making Portfolio Delta, Gamma, & Vega neutral

Security Nos. Delta
Call A
-100 0.60
Stock
+ 60 1.00
-100Call A
(-100*0.60)
+ 60 Stock
+(60*1)
= -60 + 60
=0

Gamma
1.50
0.00
(-100*1.50)
+(60*0)
= -150+ 0
= -150

Vega
1.20
0.00
(-100*1.20)
+(60*0)
= -120 + 0
= - 120

The portfolio is delta-hedged but not Gamma or Vega

neutral.
51

Making Portfolio Delta, Gamma, & Vega neutral

To make the portfolio Vega neutral, we would have to
add more call options. = - Portfolio / New Option
= - (-120/1.50) = +80 CallB
If this happens, the Delta of the portfolio will change.!!
Delta of the revised portfolio = 0 + 0.50*80 =+40
Hence, sell 40 shares for Delta neutral.
Now, to make the portfolio Gamma & Vega neutral:
Gamma: -150 + w1*2 + w2*0.80 = 0
Vega : -120 + w1*1.5 + w2*1.0 = 0
w1 = 67.5 68
w2 = 18.75 19
52

Making Portfolio Delta, Gamma, & Vega neutral

Security
Nos.
Call A
-100
Stock
20
Call B
68
Call C
19
Position Greeks

Delta Gamma
0.6
1.5
1
0
0.5
2.0
0.4
0.8
1.6
1.2

Vega
1.2
0
1.5
1.0
1

53

Making Portfolio Delta & Gamma neutral

You hold two types of calls and two types of puts on a given stock.
The deltas and gammas of the respective types are (+0.40; +0.03),
(+0.55; +0.036), (-0.63; +0.028) and (-0.40; +0.032). You have a long
position in 1,000 of the first type of call, a short position in 500 of
the second type of call, a long position in 1,000 of the first type of
put, and a short position in 500 of the second type of put.
(a) What is the aggregate delta of your portfolio? the aggregate
gamma?
(b) Suppose you decide to gamma hedge your portfolio using only
the first type of call. What is the resulting delta of the new portfolio?
What position in the underlying is now required to create a deltaneutral gamma-neutral portfolio?

54

Making Portfolio Delta & Gamma neutral

Portfolio Delta = (1000)(0.40) + (-500)(0.55) +(1000) (-0.63) +
(-500)(-0.40) = -305
Portfolio Gamma = (1000)(0.030) + (-500)(0.036)+
(1000)(0.028) + (-500)(0.032) = 24
To gamma hedge the combined position we need to sell calls
of the first type because the aggregate gamma is +24. The
number of calls needed to be sold is 24/0:03 = 800 calls.
The additional sale of 800 calls of the first type injects an
additional delta of (-800)(0.40) = -320. This increases the
existing aggregate delta of -305 to -625.
To offset this, 625 shares of the underlying need to be bought
to result in a zero-delta position.
55