GREEKS Theta

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 Theta

The theta of an option is the rate of change in its value with the passage of time, assuming
that other things remain the same

For a portfolio, the theta is the rate of change in the value of the portfolio as time passes,
given that other things are constant. A positive theta implies that the portfolio value will
increase as the time passes, while a negative theta implies that the value will decrease with
the passage of time, if there is little move in the stock price and the implied volatility

Normally expect the theta of an option to be negative as with the passage of time, an option
loses value
Exception can be an in-the money European put option on a non dividend paying stock

For at-the-money option, theta increases as the expiration date nears
Theta decreases as an option which is either out of money or in the money approaches expiration

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 Theta (cont.)

Theta (ATM) vs. Time Call / Put

0 0.2 0.4 0.6 0.8 1.0 1.2 2.5

0 2.0
1.5
1.0
-5
0.5
0
1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49
-10 -0.5
-1.0
-1.5
-15
-2.0
-2.5
-20 -3.0

Theta (Call)
Theta (Put)

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 Theta (cont.)

We have theta of call given by:
Where:

S 0 N ' ( d 1 ) S0 = Stock price at time 0, i.e. present price of
rT
( Call ) = rKe N (d 2 ) the stock
2 T
d1 and d2 are as defined in the Black-Scholes
Pricing formula earlier
e (x^2)/2 = Stock price volatility
N '(x) =
2 K = Strike price
T = Time of maturity of the option measured in
Where:
years, so that 6 months will be 0.5 years
S 0 N ' ( d 1 ) rT r = Risk neutral rate of interest
( Put ) = + rKe N ( d 2 )
2 T

For a put option, theta is given by:

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 GREEKS Gamma

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 Gamma

Gamma is the rate of change in delta for unit change in the price of the stock

For a portfolio of options with the same underlying asset, the gamma is the change in the
value of the portfolios delta with the change in the portfolio value:
A large gamma suggests that delta will change rapidly as the price of the underlying stock changes

The following table presents and compares the sign of Gamma and Delta

Option Position Delta Gamma

Call Long + +
Put Long - +
Stock Long 1 0
Call Short - -
Put Short + -
Stock Short -1 0

Gamma reaches its maximum absolute value when a stock is trading at the money or near
the money
It reduces in value as the security moves further out of the money or further in the money

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 Gamma (cont.)

Calculation of Gamma
Gamma for European options can be calculated using the following formula:
N ' ( d 1)
=
S 0 T
Where symbols have their usual meaning

Gamma (ATM) vs. Time Gamma (Call / Put)

0.45 0.07
0.40 0.06
0.35
0.05
0.30
0.25 0.04
0.20 0.03
0.15
0.02
0.10
0.05 0.01
0 0
0 0.2 0.4 0.6 0.8 1.0 1.2 1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49

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 Gamma (cont.)

Gamma Neutral Portfolio

Suppose we have a delta neutral portfolio of options that has a positive gamma
In order to make the portfolio gamma neutral one would need to undertake trades in options that
reduce the gamma to zero
However, these trades will lead to a new portfolio, which will not be delta neutral anymore
Therefore as a second step one would need to trade in stocks so that the portfolios delta neutrality
is restored
This will not impact the gamma neutrality of the portfolio as stocks carry a zero gamma

Relation between Gamma, Delta and Theta
For a delta neutral portfolio, when theta is large and negative, gamma will tend to be large and
positive. The converse of this holds too. Thus, if delta is zero and theta is large and positive, gamma is
likely to be large in magnitude and negative in sign

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