Guru. Downloaded March 14, 2020.

The information provided in this document is intended solely for you. Please do not freely distribute.

P1.T4.Valuation & Risk Models

Chapter 16. Option Sensitivity Measures:

The “Greeks”

Bionic Turtle FRM Study Notes

By David Harper, CFA FRM CIPM

www.bionicturtle.com
Guru. Downloaded March 14, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.

Chapter 16. Option Sensitivity Measures: The “Greeks”

DESCRIBE AND ASSESS THE RISKS ASSOCIATED WITH NAKED AND COVERED OPTION POSITIONS
.......................................................................................................................................... 3
DESCRIBE THE USE OF A STOP LOSS HEDGING STRATEGY, INCLUDING ITS ADVANTAGES AND
DISADVANTAGES, AND EXPLAIN HOW THIS STRATEGY CAN GENERATE NAKED AND COVERED
OPTION POSITIONS. ............................................................................................................. 4
DESCRIBE DELTA HEDGING FOR AN OPTION, FORWARD, AND FUTURES CONTRACTS ................. 5
COMPUTE DELTA OF AN OPTION ........................................................................................... 6
DESCRIBE THE DYNAMIC ASPECTS OF DELTA HEDGING DISTINGUISH BETWEEN DYNAMIC
HEDGING AND HEDGE-AND-FORGET STRATEGY. .................................................................... 8
DEFINE AND CALCULATE THE DELTA OF A PORTFOLIO .......................................................... 11
DEFINE AND DESCRIBE THETA, GAMMA, VEGA, AND RHO FOR OPTION POSITIONS, AND
CALCULATE THE GAMMA AND VEGA FOR A PORTFOLIO. ........................................................ 12
EXPLAIN HOW TO IMPLEMENT AND MAINTAIN A DELTA-NEUTRAL AND A GAMMA‐NEUTRAL
POSITION .......................................................................................................................... 16
DESCRIBE THE RELATIONSHIP BETWEEN DELTA, THETA, GAMMA AND VEGA ........................... 17
DESCRIBE HOW PORTFOLIO INSURANCE CAN BE CREATED THROUGH OPTION INSTRUMENTS AND
STOCK INDEX FUTURES...................................................................................................... 19
CHAPTER SUMMARY ......................................................................................................... 21
QUESTIONS AND ANSWERS ............................................................................................... 23

2
Guru. Downloaded March 14, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.

Chapter 16. Option Sensitivity Measures: “The Greeks”

 Describe and assess the risks associated with naked and covered option
positions.

Describe the use of a stop loss hedging strategy, including its advantages and
disadvantages, and explain how this strategy can generate naked and covered option
positions.

 Describe delta hedging for an option, forward, and futures contracts.

 Compute delta of an option.

 Describe the dynamic aspects of delta hedging and distinguish between dynamic
hedging and hedge-and-forget strategy.

 Define and calculate the delta of a portfolio.

 Define and describe theta, gamma, vega, and rho for option positions, and
calculate the gamma and vega for a portfolio.

 Explain how to implement and maintain a delta-neutral gamma-neutral position.

 Describe the relationship between delta, theta, gamma and vega

 Describe how portfolio insurance can be created through option instruments and
stock index futures.

Describe and assess the risks associated with naked and covered
option positions
If you sell a call option without owning the underlying asset, you hold a naked position (i.e.,
you have no hedge whatsoever). If you sell a call option while owning the shares, you have a
covered position. Neither does it provide a good hedge. If you hold a naked position, you
lose when the call is exercised. If you hold a covered position, you lose if the stock drops.

For example, consider a financial institution that has sold for $300,000 a European call
option on 100,000 shares of a non-dividend-paying stock. Assumptions are:
 Stock price (S0) is $ 49
 Strike (K) is $ 50
 Volatility (σ) is 20%
 Term (t) is six months 0.3846 (20 weeks)
 Riskless rate is 5 %
The Black–Scholes–Merton value of an option to buy one share is $2.40. Therefore, the
price of the option is about $240,000. The financial institution has therefore sold a product
for $60,000 more than its theoretical value. But it is faced with the problem of hedging the
risks.

3
Guru. Downloaded March 14, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.

Naked position: The institution does nothing other than selling its stock option. This
strategy works well if the stock price is below $50 at the end of the 20 weeks. The option
then costs the financial institution nothing and it makes a profit of $300,000.

However, if the call is exercised then the institution has to buy 100,000 shares at the market
price prevailing in 20 weeks to cover the call. For example, if after 20 weeks the stock price
is $60, the option costs the financial institution $1,000,000(stock price minus strike price
times the no. of shares). This is considerably greater than the $300,000 charged for the
option.

Covered position: This involves buying 100,000 shares as soon as the option has been
sold. If the option is exercised, this strategy works well.

However, if the stock price drops it could lead to a significant loss. For example, if the stock
price drops to $40, the financial institution loses $900,000 (fall in the price of stock times the
no. of shares) on its stock position. This is considerably greater than the $300,000 charged
for the option.

Neither a naked position nor a covered position provides a good hedge. If the
assumptions underlying the Black–Scholes–Merton formula hold, the cost to the financial
institution should always be $240,000 on average for both approaches. But on any one
occasion the cost is liable to range from zero to over $1,000,000. A good hedge would
ensure that the cost is always close to $240,000.

Describe the use of a stop loss hedging strategy, including its

advantages and disadvantages, and explain how this strategy can
generate naked and covered option positions.
The stop loss trading strategy is to hold a naked position when the option is out-of-the-
money and a covered position when the option is in-the-money. This procedure ensures the
institution owns the stock if the option closes in the money and does not own it if the option
closes out of the money.

Stop-loss Strategy

 Write call option with strike price = K

 When stock price rises above K (when option is in-the-money)
o Buy one share (“Cover the position”)
 When stock price falls below K (when option is out-of-the-money)
o Sell the share (“Go naked”)
Although “superficially attractive,” this strategy becomes too expensive if the stock price
crosses the strike price level many times due to increased transaction costs. Also, every
purchase and subsequent sale involves a cost (apart from transaction costs) because we
cannot assume that purchases and sales are made at the same price every time. Stop-loss
is also considered an inferior hedging scheme.

4
Guru. Downloaded March 14, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.

Describe delta hedging for an option, forward, and futures

contracts
Delta of options

Delta is the rate of change of the option price with respect to the price of the
underlying asset. That is, it is the slope of the curve that relates the option’s price to the
underlying asset price.
= change in the price of the call option
= ∆= ;
= change in the price of the stock option

The greater the underlying value, call option values increase whereas put option values
decrease. ( ) measures the slope of this line at a given point. So, the delta of European
call option on stocks that pay no dividends is given by ( ) and the delta of European put
option on stocks that pay no dividends is given by ( ) − 1.

In case of stocks that yield dividend at rate , the delta of European call option is given by
− ( )and the delta of European put option is given by − [ ( ) − 1].

Delta of Forward Contracts

Consider a forward contract on a non-dividend-paying stock whose value is given as:

−

When the price of the stock changes by ∆ , with all else remaining the same, the value of a
forward contract on the stock also changes by ∆ . The delta of a long forward contract on
one share of the stock is therefore always 1.0.

For an asset providing a dividend yield at rate , the forward contract’s delta is .

Delta of Futures Contract

The futures price for a contract on a non-dividend-paying stock is given by: .

This shows that when the price of the stock changes by ∆ , with all else remaining the
same, the futures price changes by ∆ . Since futures contracts are settled daily, the
holder of a long futures position makes an almost immediate gain of this amount. The delta
of a futures contract is therefore .

( )
For a futures position on an asset providing a dividend yield at rate , delta is .

5
Guru. Downloaded March 14, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.

To summarize:

Delta of an option

∆= ( ) European call on non-dividend stock

∆= ( ) − 1 European put on non-dividend stock
∆= − ( ) European call on asset paying dividend rate of (q)
∆= − [ ( ) − 1] European put on asset paying dividend rate of (q)

Delta of a forward contract

∆= 1 Delta of forward contract on one share of stock.
∆= delta of a forward contract, asset pays dividend rate of (q)

Delta of a futures contract

∆= Delta of futures position

∆= ( − ) Delta of futures position, asset pays dividend rate of (q)

Compute delta of an option

As we have seen from the definition of delta, when a stock price changes by a small amount
(∆ ), the option price changes by about ∆% of that amount.

Delta is closely related to the Black–Scholes–Merton analysis. The Black–Scholes–Merton

differential equation can be derived by setting up a riskless portfolio consisting of a short
position in an option on a stock and a long position in the stock in terms of ∆, as:

(-1: option, + ∆: shares of the stock).

The option is then valued by setting up a delta-neutral position and arguing that the return on
the position should (instantaneously) be the risk-free interest rate.

For example, consider a European call option on 100,000 shares of a non-dividend-paying

stock where the stock price is $49, the strike price is $50, the risk-free rate is 5%, the time to
maturity is 20 weeks (0.3846 years), and the volatility is 20%. In this case,

ln(49/50 )+ 0.05+ 0.2 2 /2 0.38 46

= = 0.0 542. So ( ) is found to be 0.522.
0.2 √0.3846

We know that the delta of European call option on stocks that pay no dividends is given by
( ).This means when the stock price changes by ∆ , the option price changes by
0.522∆ .

The chart below plots delta as a function of stock price. Call option values definitely increase
the greater the underlying value and put option values definitely decrease. So, as stock
prices increase towards K, delta of calls which is positive tend towards 1, while delta of puts
which is negative tend towards zero.

6
Guru. Downloaded March 14, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.

Delta as a function of stock price

As delta is positive for calls, the short position in a call option is hedged by a long position in
the underlying stock and vice versa. As delta is negative for puts, a short position in a put
option is hedged by short position in the underlying and vice versa.

This chart below plots delta as a function of time to maturity for in-the-money, at-the-money
and out-of-the money options.

Delta as a function of time to maturity

7
Guru. Downloaded March 14, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.

Describe the dynamic aspects of delta hedging distinguish between

dynamic hedging and hedge-and-forget strategy.
Delta hedging aims to maintain an unchanged value of the net position. A position with a
delta of zero is called a delta neutral position.

However, since the delta of an option does not remain constant, the trader’s position
remains delta hedged only instantaneously (for a very short period of time). The hedge has
to be adjusted periodically to maintain a delta neutral position. For instance, the stock price
might increase as a result of which the delta increases and so more number of shares would
have to be purchased to maintain the hedge. This is known as rebalancing.
 Rebalancing is required more frequently if delta changes more rapidly; if gamma is
higher (such as the case when the options are at-the-money), rebalancing is required
more often.
 On the other hand, when gamma is lower (such is the case when options are deeply
in the money or deeply out of the money), rebalancing is required less frequently.
Thus, a procedure in which the hedge is adjusted on a regular basis is referred to as
dynamic hedging. Holding a genuine delta-neutral position requires dynamic (continual)
rebalancing. In reality this is impossible due to the prohibitively large transaction costs this
would entail. In static hedging, a hedge is set up initially and never adjusted. Static hedging
is also referred to as ‘‘hedge-and-forget”.

Dynamic Hedging Examples

E.g.: We consider the example of a European call option on 100,000 shares of a non-
dividend-paying stock where the stock price is $49, the strike price is $50, the risk-free rate
is 5%, the time to maturity is 20 weeks (0.3846 years), and the volatility is 20%. The hedge
is assumed to be adjusted or rebalanced weekly. This hedge illustrates a sequence of
events such that the option closes in the money.

In this case, as seen in the table below we calculated the initial value of delta for a single
option to be 0.522. This means that the delta of the option position is initially -52,200(-
100,000 × 0.522). When the option is written, $2,557,800 (52,200 bought at a price of $49)
must be borrowed to create a delta-neutral position. With the rate of interest given at 5%, an
interest cost of approximately $2,500 is incurred in the first week.

By the end of first week, the stock price falls and the delta of the option declines, so that the
new delta of the option position is 45,800. So, 6,400 of the shares initially purchased are
sold to maintain the delta-neutral hedge. The strategy realizes $308,000 in cash, and the
cumulative borrowings at the end of Week 1 are reduced to $2,251,000.

Likewise, every week positions are adjusted to maintain the delta-neutral hedge. Toward the
end of the life of the option, the option will be exercised and the delta of the option
approaches 1.0.

By Week 20, the hedger has a fully covered position. The hedger receives $5 million for the
stock held, so that the total cost of writing the option and hedging it is $207,000.

8
Guru. Downloaded March 14, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.

Simulation of delta hedge: option closes in the money

Cost of
shares Cum. Cost
Stock Price Delta: Shares purchased Incl Int Interest
Week Term ($) N(d1) Purchased ($000) ($000) Cost ($000)
0 0.3846 49.00 0.522 52,200 2,558 2,558 2.5
1 0.3654 48.12 0.458 -6,400 -308 2,251 2.2
2 0.3462 47.37 0.400 -5,800 -275 1,977 1.9
3 0.3269 50.25 0.596 19,600 985 2,962 2.9
4 0.3077 51.75 0.693 9,700 502 3,465 3.4
5 0.2885 53.12 0.774 8,100 430 3,897 3.8
6 0.2692 53.00 0.771 -300 -16 3,882 3.8
7 0.2500 51.87 0.706 -6,500 -337 3,546 3.5
8 0.2308 51.38 0.674 -3,200 -164 3,382 3.3
9 0.2115 53.00 0.787 11,300 599 3,982 3.9
10 0.1923 49.88 0.550 -23,700 -1,182 2,800 2.8
11 0.1731 48.50 0.413 -13,700 -665 2,136 2.1
12 0.1538 49.88 0.542 12,900 644 2,780 2.7
13 0.1346 50.37 0.591 4,900 247 3,027 3.0
14 0.1154 52.13 0.768 17,700 923 3,951 3.9
15 0.0962 51.88 0.759 -900 -47 3,904 3.9
16 0.0769 52.87 0.865 10,600 560 4,465 4.4
17 0.0577 54.87 0.978 11,300 620 5,085 5.0
18 0.0385 54.62 0.990 1,200 66 5,151 5.1
19 0.0192 55.87 1.000 1,000 56 5,207 5.2
20 0.0000 57.25 1.000 0 0 5,207

E.g.: For the same set of assumptions considered in the example above except for the stock
price, we depict an alternative sequence of events such that the option closes out of the
money. This is depicted in the table below.

In this case also, we maintain a delta neutral strategy but as we see the option will not be
exercised, and delta approaches zero. By Week 20 the hedger has a naked position and has
incurred costs totaling $223,000.

In both examples, initially, the value of the written option based on BSM model is $240,000.
Dynamic delta hedging aims to keep the value of the position as close to unchanged as
possible from this value. However, in our examples since the hedge is rebalanced only once
a week there may be slight variations in cost of hedging after discounting back the cost to
the initial time period. If frequency of hedging is increased these values would be close to
the BSM price.

9
Guru. Downloaded March 14, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.

Simulation of delta hedge: option closes out of the money

Cost of
shares Cum. Cost
Stock Price Delta: Shares purchased Incl Int Interest
Week Term ($) N(d1) Purchased ($000) ($000) Cost ($000)
0 0.3846 49.00 0.522 52,200 2,558 2,558 2.5
1 0.3654 49.75 0.568 4,600 229 2,788 2.7
2 0.3462 52.00 0.705 13,700 712 3,501 3.5
3 0.3269 50.00 0.579 -12,600 -630 2,872 2.8
4 0.3077 48.38 0.459 -12,000 -581 2,292 2.2
5 0.2885 48.25 0.443 -1,600 -77 2,216 2.2
6 0.2692 48.75 0.475 3,200 156 2,373 2.3
7 0.2500 49.63 0.540 6,500 323 2,696 2.6
8 0.2308 48.25 0.420 -12,000 -579 2,117 2.1
9 0.2115 48.25 0.410 -1,000 -48 2,070 2.0
10 0.1923 51.12 0.658 24,800 1,268 3,338 3.3
11 0.1731 51.50 0.692 3,400 175 3,514 3.5
12 0.1538 49.88 0.542 -15,000 -748 2,766 2.7
13 0.1346 49.88 0.538 -400 -20 2,746 2.7
14 0.1154 48.75 0.400 -13,800 -673 2,074 2.0
15 0.0962 47.50 0.236 -16,400 -779 1,295 1.2
16 0.0769 48.00 0.261 2,500 120 1,415 1.4
17 0.0577 46.25 0.062 -19,900 -920 495 0.4
18 0.0385 48.13 0.183 12,100 582 1,077 1.0
19 0.0192 46.63 0.007 -17,600 -821 257 0.2
20 0.0000 48.12 0.000 -700 -34 223

Delta hedging is a great improvement over a stop-loss strategy because the performance of
a delta-hedging strategy gets steadily better as the hedge is monitored more frequently and
continuously (dynamically).

10
Guru. Downloaded March 14, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.

Define and calculate the delta of a portfolio

If a portfolio of options valued at is dependent on a single asset whose price is , then the
delta of the portfolio is given by:

Portfolio =∆ =

The delta of a portfolio can be calculated as the sum of the product of each option
position and its delta in a portfolio.

Portfolio =∆ = ∆
=1

For example, a financial institution has the following three positions in options on a stock:
 A long position in 100,000 call options with strike price $55 and an expiration date in
3 months. The delta of each option is 0.533.
 A short position in 200,000 call options with strike price $56 and an expiration date in
5 months. The delta of each option is 0.468.
 A short position in 50,000 put options with strike price $56 and an expiration date in 2
months. The delta of each option is -0.508.

The delta of the portfolio is:

∆ = ∆ = (100,000 × 0.533) − (200,00 0 × 0.468) − (50,000 × − 0.508)

= − 14,900

This means that the portfolio can be hedged (made delta neutral) by buying 14,900 shares of
the underlying asset.

11
Guru. Downloaded March 14, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.

Define and describe theta, gamma, vega, and rho for option
positions, and calculate the gamma and vega for a portfolio.
Theta

Theta is the rate of change of the value of the portfolio with respect to the passage of
time (keeping all other things equal). As expiration approaches, the option price moves
toward the payoff value of the option at expiration, and so theta is also called time decay.

Theta is the one Greek here that is “deterministic:” the change in maturity (the time
dimension) is known and can be predicted, unlike, say, volatility or the asset price dynamics
that is stochastic (random).

Given below are plots for the theta of a European call and put option. We chart theta as a
function of the stock price and as a function of time to maturity. Theta is usually negative for
an option because, as time passes with all else remaining the same, the option tends to
become less valuable.
Theta as a function of the stock price

Theta as a function of the time to maturity

12
Guru. Downloaded March 14, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.

Gamma
Gamma is the rate of change of the portfolio’s delta with respect to the underlying
asset; it is therefore a second partial derivative of the portfolio.

Delta measures only the slope for a very small change in the underlying. When the
underlying changes by more than a very small amount, the curvature of the line comes into
play and distorts the relationship between the option price and underlying price that is
explained by the delta. Gamma captures this curvature effect.

2
Π Π = the second partial derivative of the call price
=Γ=
2 = the second partial derivative of the stock price

If gamma is small, delta changes slowly, and if gamma is highly negative or highly positive,
delta is very sensitive to the price of the underlying asset. Then to maintain the delta-neutral
position, the portfolio has to be rebalanced frequently. Below are the plots for the Gamma of
a European call and put option, as a function of stock price and time to maturity. Gamma
tends to be large when the option is at-the-money and close to expiration, when there
is more uncertainty about whether the option will expire in- or out-of-the-money.

Gamma as a function of the stock price

Gamma as a function of time to maturity

13
Guru. Downloaded March 14, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.

Vega

Vega is the rate of change of the value of a portfolio (of derivatives) with respect to
the volatility of the underlying asset.

Π
=

If vega is highly positive or highly negative, the portfolio’s value is very sensitive to small
changes in volatility. If it is close to zero, volatility changes have relatively little impact on the
value of the portfolio.

Here are the plots for Vega of a European call and put option against the stock price and
time to maturity. Note that vega is positive for both calls and puts, meaning that if the
volatility increases, both call and put prices increase. Also, the vega is larger the closer the
option is to being at-the-money.

Vega as function of stock price

Vega as a function of time to maturity

14
Guru. Downloaded March 14, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.

Rho

Rho is the rate of change of the value of a portfolio (of derivatives) with respect to the
interest rate (or, as in the Black–-Scholes, the risk-free interest rate):

Π
ℎ =

It measures the sensitivity of the value of a portfolio to a change in the interest rate when all
else remains the same.

On the charts below, we chart rho versus stock price and maturity for a European call and
put option.

Rho as function of stock price

Rho as function of time to maturity

15
Guru. Downloaded March 14, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.

Explain how to implement and maintain a delta-neutral and a

gamma‐neutral position
To change the gamma of the portfolio, we require a position in an instrument such as an
option that is not linearly dependent on the underlying asset. Assume that a delta-neutral
portfolio has a gamma of (Γ) and a traded option has a gamma of (Γ ). The position in the
traded option necessary to make the portfolio gamma neutral is given by:

−Γ
Number of additional options =
Γ
Including the traded option is likely to change the delta of the portfolio, so the position in the
underlying asset then has to be changed to maintain delta neutrality. While delta neutrality
provides protection against relatively small stock price moves between rebalancing, gamma
neutrality provides protection against larger movements in this stock price between hedge
rebalancing.

For example, assume a portfolio is delta neutral with position gamma of -3,000. Greek (per
option) delta is 0.62 and Greek gamma is 1.5.

To neutralize the -3,000 position gamma, we take a long position in 2,000 call options
because this adds +3,000 position gamma (+2,000 * 1.5). However, these options add
+1,240 position delta (+2,000 * 0.62).

Again, to neutralize this 1,240 position delta, we short 1,240 shares (a share has delta = 1.0
and zero Greek gamma!). Now both delta and gamma are neutralized.

Example:
Position Delta 0
Position Gamma -3,000
Per Option
Delta 0.62
Gamma 1.5

Making the portfolio gamma neutral

1. Add options (+ is long, - is short)
= 2000 long calls
Gamma 3,000 .
Number of options 2,000
Additional delta 1,240 2000 × 0.62 = 1240 shares
2. Correct the delta
Number of shares (to sell) -1,240

16
Guru. Downloaded March 14, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.

Describe the relationship between delta, theta, gamma and vega

The risk-free rate multiplied by the portfolio (i.e., a fractional share of the portfolio) is
directly related to a linear function of theta, delta and gamma:

1
Π =Θ+ Δ+ Γ
2
= risk-free interest rate
Π= value of the portfolio
Θ= option theta
= stock price
Δ =option delta
= variance of underlying stock
Γ = option gamma

For example: In the table below, we can see that Π (last column) is equal to the value
ofΘ + Δ + Γ (addition of second, third and fourth columns respectively).

Also, delta is zero by definition in a “delta-neutral” portfolio, in which case the formula
simplifies to:

1
Π =Θ+ Γ
2
This shows that if theta is large and positive, then gamma of a portfolio tends to be large and
negative and vice versa. This is depicted in the chart below the table. This explains why
theta can to some extent be regarded as a proxy for gamma in a delta-neutral portfolio.

Option price inputs

1 Stock (S) $100.00
2 Strike (K) $80.00
3 Volatity, σ 30.0%
Variance, σ^2 9.00%
4 Riskfree rate, r 4.00%
5 Term, T 1.00
6 Div Yield, q 0.00%

0.5*σ^2*S Sum of
^2*d2c/dS Col 2 + 4 +
Term Theta(c) Gamma r*S*delta 2 5 r * Value
1 -5.887 0.0078 3.391 3.531 1.035 1.035
2 -4.799 0.0061 3.292 2.754 1.247 1.247
3 -4.123 0.0050 3.285 2.262 1.424 1.424
4 -3.651 0.0043 3.304 1.926 1.579 1.579
5 -3.292 0.0037 3.332 1.678 1.718 1.718
6 -3.005 0.0033 3.363 1.485 1.844 1.844
7 -2.765 0.0030 3.395 1.330 1.959 1.959
8 -2.561 0.0027 3.426 1.201 2.065 2.065
9 -2.383 0.0024 3.456 1.092 2.164 2.164
10 -2.226 0.0022 3.484 0.998 2.256 2.256

17
Guru. Downloaded March 14, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.

Theta Vs Gamma

Theta can (to some extent) be regarded as a proxy for gamma in a delta-neutral
portfolio

Vega of the option is the change in the rate of change in its value with respect to the volatility
of the underlying asset. A position in the underlying asset has zero vega. Vega cannot
therefore be changed by taking a position in the underlying asset. In this respect, vega is like
gamma. A complication is that different options in a portfolio are liable to have different
implied volatilities. If all implied volatilities are assumed to change by the same amount
during any short period of time, vega can be treated like gamma and the vega risk in a
portfolio of options can be hedged by taking a position in a single option. If ˅ is the vega of
the portfolio, and ˅T is the vega of the traded option, a position of -˅/˅T in the traded option
makes the portfolio instantaneously vega neutral. Unfortunately, a portfolio that is gamma
neutral will not in general be vega neutral, and vice versa. If a hedger requires a portfolio to
be both gamma and vega neutral, at least two traded options dependent on the underlying
asset must be used.

18
Guru. Downloaded March 14, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.

Describe how portfolio insurance can be created through option

instruments and stock index futures
The typical approach to creating portfolio insurance is to acquire a put option. This
provides protection against market declines while preserving the potential for a gain if the
market does well. For example, a portfolio manager may buy a put on the S&P 500 index.

The alternative is to create the option synthetically by shorting a futures contract.

Creating an option synthetically involves maintaining a position in the underlying asset so
that the delta of the position is equal and opposite to the delta of the required option. The
synthetic option can be created from:
 Trading the portfolio: Trading the portfolio involves splitting the portfolio between
equities and risk-free securities. As the market declines, more is invested in risk-free
securities. As the market increases, more is invested in equities.
 Trading in index futures: Trading index futures involves keeping the equity portfolio
intact and selling index futures. As the market declines, more index futures are sold;
as it rises, fewer are sold.
For example: Here we examine how synthetic option is created from trading the portfolio.
A portfolio is worth $90 million. To protect against market downturns a 6-month European
put option on the portfolio with a strike price of $87 million is required. The risk-free rate is
9% per annum, the dividend yield is 3% per annum, and the volatility of the portfolio is 25%
per annum.

The S&P 500 index stands at 900. As the portfolio is considered to mimic the S&P 500 fairly
closely, one alternative, is to buy 1,000 put option contracts on the S&P 500 with a strike
price of 870. Another alternative is to create the required option synthetically.

We know that the delta of a European put option on an asset paying dividend is [ ( −
1)].To create the put option synthetically, the fund manager should ensure that at any given
time a [ (1 − )] proportionof the stocks in the original portfolio has been sold and the
proceeds invested in riskless assets. As the value of the original portfolio declines, the delta
of the put given by equation becomes more negative and the proportion of the original
portfolio sold must be increased. As the value of the original portfolio increases, the delta of
the put becomes less negative and the proportion of the original portfolio sold must be
decreased (i.e., some of the original portfolio must be repurchased).

As shown in the table below we find the required delta of the put option to be -0.3215. This
means 32.15% of the portfolio should be sold initially and invested in risk-free assets to
match the delta of the required option. The amount of the portfolio sold must be monitored
frequently. For example, if the value of the portfolio reduces to $88 million after 1 day, the
delta of the required option changes to 0.3679 and a further 4.64% of the original portfolio
should be sold and invested in risk-free assets. If the value of the portfolio increases to $92
million, the delta of the required option changes 0.2787 and 4.28% of the original portfolio
should be repurchased.

19
Guru. Downloaded March 14, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.

Example: Portfolio Insurance – Creating Synthetic Put option

Inputs European Put

1 Stock (S0) $900.00 d1 0.4499
Stock (S0) $880.00 N(d1) 0.6736
Stock (S0) $920.00 Delta if S0 is 900 -0.3215
2 Strike (K) $870.00 d1 0.3227
3 Volatity, σ 25.0% N(d1) 0.6266
Variance, σ^2 6.25% Delta if S0 is 880 -0.3679
4 Riskfree rate, r 9.00% d1 0.5742
5 Term, T 0.50 N(d1) 0.7171
6 Div Yield, q 3.00% Delta if S0 is 920 -0.2787

For example: Here we see how index futures can create options synthetically. They are
preferred mostly because the transaction costs associated with trades in index futures are
lower than those trades in the underlying stocks. If the portfolio is worth times the index
and each index futures contract is on times the index, the number of futures contracts
shorted at any given time, if ∗ is the maturity of the futures contracts should be:

( ∗ ) ∗
[1 − ( )] /

Assume that in the previous example, futures contracts on the S&P 500 maturing in 9
months are used to create the option synthetically. In this case, initially ∗ is 0.75, is
100,000, and d1 is 0.4499. Each index futures contract is on 250 times the index, so that
is250. The number of futures contracts shorted using the equation above, should be:

0.0 3(0.75− 0.5) − 0.0 9∗0.75 [1 − 0.6736)]1 00,000/250 ≅ 123

As time passes and the index changes, the position in futures contracts must be adjusted.
This analysis assumes that the portfolio mirrors the index. If not, it is necessary to calculate
the portfolio’s beta to find the position in options on the index that gives the required
protection and choose a position in index futures to create the options synthetically.

20
Guru. Downloaded March 14, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.

Chapter Summary
Financial institutions are often faced with the problem of hedging their exposure. Since
neither a naked position nor a covered position provides a good hedge, they are subject to
an unacceptable level of risk. A stop-loss strategy wherein holding a naked position when an
option is out of the money and converting it to a covered position as soon as the option
moves into the money seems to be a good solution. However, although superficially
attractive, this strategy is considered an inferior hedging scheme as it could turn out to be
very expensive.

Now we come to the discussion on Greeks, which are measures of the risks on an option
position. In short:
 The change in the option price for a change in the price of the underlying is called the
delta.
 The change in delta for a change in the price of the underlying is called the gamma
 The change in the option price for a change in the risk-free rate is called the rho.
 The change in the option price for a change in the time to expiration is called the
theta.
 The change in the option price for a change in the volatility is called the vega.

The delta (∆) of an option is the rate of change of its price with respect to the price of the
underlying asset. Delta hedging involves creating a position with zero delta (or delta-neutral
position). Because the delta of the underlying asset is 1.0, one way of hedging is to take a
position of (− ∆)in the underlying asset for each long option being hedged.

The delta of an option remains hedged only for a relatively short period of time. Therefore,
holding a genuine delta-neutral position requires dynamic (continual) rebalancing. Once an
option position has been made delta neutral, the next stage is often to look at its gamma (Γ).

The gamma of an option is the rate of change of its delta with respect to the price of the
underlying asset. If gamma is small, delta changes slowly, and if gamma is highly negative
or highly positive, delta is very sensitive to the price of the underlying asset. The impact of
changes in gamma on the performance of delta hedging can be reduced by making an
option position gamma neutral. If Γis the gamma of the position being hedged, this reduction
is usually achieved by taking a position in a traded option that has a gamma of − Γ.

Delta and gamma hedging are both based on the assumption that the volatility of the
underlying asset is constant. In practice, volatilities change over time. The vega of an option
or an option portfolio measures the rate of change of its value with respect to volatility. An
option position can be hedged against volatility changes by taking an offsetting position in a
traded option so as to make the vega neutral.

Theta measures the rate of change of the value of the position with respect to the passage
of time, with all else remaining constant. Rho measures the rate of change of the value of
the position with respect to the interest rate, with all else remaining constant.

21
Guru. Downloaded March 14, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.

In practice, option traders usually rebalance their portfolios at least once a day to maintain
delta neutrality. It is usually not feasible to maintain gamma and vega neutrality on a regular
basis and so traders only monitor these measures. If they get too large, either corrective
action is taken, or trading is curtailed. In addition to monitoring delta, gamma, and vega,
traders also carry out scenario analysis by calculating gains/losses on portfolio over
specified period under variety of scenarios.

The risk-free rate times the portfolio value is a linear function of theta, delta and gamma.
Since delta is zero in a “delta-neutral” portfolio, theta can to some extent be regarded as a
proxy for gamma in a delta-neutral portfolio.

Portfolio insurance is created by acquiring a put option or by synthetically shorting a futures

contract. Synthetic options can be created from trading the portfolio or by trading index
futures on the portfolio. While portfolio insurance works well in normal market conditions they
do not seem to offer much respite during turbulent market conditions.

22
Guru. Downloaded March 14, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.

Questions and Answers

1. In sequence FROM LOWEST to highest value of option delta, what is the correct order of
the following four options: in-the-money (ITM) call option, out-of-the-money (OTM) call
option, in-the-money (ITM) put option, and out-of-the-money (OTM) put option?
a) OTM put, OTM call, ITM call, ITM put
b) OTM call, ITM call, ITM put, OTM put
c) ITM call, ITM put, OTM put, OTM call
d) ITM put, OTM put, OTM call, ITM call

2. A market maker today writes 100 at-the-money (ATM) call option contracts (i.e., short
10,000 options) and immediately starts a dynamic delta hedge by purchasing the underlying
non-dividend-paying shares, but due to transaction costs will only re-balance weekly. Next
week the underlying share price, volatility and risk-free rate are unchanged. What is the next
week's dynamic delta hedge trade?
a) Sell some amount of shares (reduced long position in shares)
b) No transaction (maintain long position in shares)
c) Buy some amount of shares (increase long position in shares)
d) Not enough information (we need the option delta)

3. If at-the-money (ATM) options are otherwise identical, which of the following will have the
LOWEST value of rho?
a) Put with distant time to expiration
b) Put near to expiration
c) Call near to expiration
d) Call with distant time to expiration

4. A delta-neutral option portfolio has a large and positive position theta. Which of the
following trades is most likely to neutralize the portfolio's gamma?
a) Buy call options
b) Write put options
c) Sell shares
d) None of the above: theta must be negative!

23
Guru. Downloaded March 14, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.

Answers

1. D. ITM put, OTM put, OTM call, ITM call

ITM put has lowest value as deep ITM put approaches -1.0
OTM put has next highest value as deep OTM put approaching zero but always negative
OTM call has next highest value as deep OTM call approaching zero but always positive,
and ITM call has highest value as deep ITM call approaching 1.0

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t4-6-option-

delta.4829/#post-12819

2. A. Sell some amount of shares (reduced long position in shares)

Next week, the percentage delta due to a slightly shorter maturity, ceteris paribus, must be
slightly lower. The position delta on the written calls must therefore INCREASE from a
negative to a slightly higher negative. For example, if today's percentage delta is 0.57 and,
due only to a maturity of one week less, next week's percentage delta is 0.56, then the
position delta increases from -5,700 to -5,600. As today's delta hedge is long 5,700 shares,
next week 100 shares must be sold to maintain delta neutrality.

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t4-7-dynamic-delta-

hedging.4838/#post-12868

3. A. Put with distant time to expiration

Rho is positive for calls and negative for puts, with interest rate having the most impact when
expiration is distant.
Rho (put) = -K*T*exp(-rT)*N(-d2), such that Rho(put) is a decreasing function with increasing
(T).

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t4-8-option-

greeks.4848/#post-12896

4. A. Buy call options

Percentage theta is typically negative. A SHORT option position, in either calls or puts,
therefore typically has positive position theta. Nevertheless, per Hull 17.4, in a delta-neutral
portfolio, a large and positive position theta implies a large and negative position gamma. To
neutralize gamma, the trade needs to add positive position gamma; i.e., either buy calls or
puts.
 In regard to (B), writing puts adds negative position gamma.
 In regard to (C), shares have zero gamma (i.e., constant delta = 1.0).

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t4-9-gamma-neutral-

option-positions.4867/#post-12982

24