The Greek Letters

Chapter 17
1

The Greeks are coming!

The Greeks are coming!
Parameters of SENSITIVITY
Delta =
Theta =
Gamma =
Vega =
Rho =
2

c = SN(d1) Ker(T t)N(d2)

p = Ker)T t)N(-d2) SN(-d1)
Notationally:
c = c(S; K; T-t; r; )
p = p(S; K; T-t; r; )
Once c and p are calculated, WHAT IF?

The GREEKS are measures of

sensitivity. The question is how
sensitive a positions value is to
changes in any of the variables that
contribute to the positions market
value.These variables are:
S, K, T-t, r and .
Each one of the Greek measures
indicates the change in the value of
the position as a result of a small
change in the corresponding variable.
Formally, the Greeks are partial

Delta =
In mathematical terms DELTA is the
first derivative of the options
premium with respect to S. As such,
Delta carries the units of the options
price; I.e., $ per share.
For a Call: (c)= c/S
For a Put:
Results:

(p)

= p/S

(p) = (c) - 1
5

THETA

Theta measures are given by:

(c) = c/(T-t) (p)

= p/(T-t)

s are positive but the they are

reported as negative values. The

negative sign only indicates that as
time passes, t increases, time to
expiration, T t, diminishes and so
does the options value, ceteris
paribus. This loss of value is labeled
the options time decay.
6

GAMMA
Gamma measures the change in delta
when the price of the underlying asset
changes.
Gamma is the second derivative of the
options price with respect to the
underlying price.
(c) = (c)/S = 2c/ S2
(p) = (p)/S = 2p/ S2
Results:

(c) = (p)
(S) = 0.

VEGA

Vega measures the sensitivity of the

options market price to small
changes in the volatility of the
underlying
assets return.
(c) = c/
(p)

= p/

Thus, Vega is in terms of

$/1% change in .
(S)

= 0.

RHO

Rho measures the sensitivity of the

options price to small changes in
the rate of interest.
(c) = c/r
(p)= p/r
Rho is in terms of $/%change of r.
(S) = 0.
9

Example:
S=100; K = 100; r = 8%;
days;

= 30%.
Premium

T-t =180

Call

Put

$10.3044

$6.4360

The Greeks:
Delta =
0.6151
0.3849
Theta = -0.03359
Gamma = 0.0181
0.0181

-0.01252
10

Again. the Delta of any position

measures the $ change/share in
the positions value that ensues
a small change in the value of
the underlying.
(c)= 0.6151
(p) = - 0.3849

11

Call Delta (See Figure 15.2, page 345)

Delta is the rate of change of the call
price with respect to the underlying

Call price

Slope =

C
A

Stock price

12

THETA

Theta measures the sensitivity of the options

price to a small change in the time
remaining to expiration:
(c) = c/(T-t) (p)= p/(T-t)

Theta is given in terms is $/1 year.

(c) = - $12.2607/year if time to
expiration increases (decreases) by
one year, the call price will increase
(decrease) by $12.2607. Or,
12.2607/365 = 3.35 cent per day. 13

GAMMA
Gamma measures the change in delta
when the price of the underlying asset
changes.
= 0.0181. (c) = .6151;
-.3849.

(p) =

If the stock price increases to $101:

(c) increases to
.
6332
(p) increases to
-.3668.
If the stock price decreases to $99:14

VEGA

Vega measures the sensitivity of

the options market price to
small changes in the volatility
of the underlying assets return.
=

.268416

(Check on Computer)

15

RHO

Rho measures the sensitivity of

the options price to small
changes in the rate of interest.
Rho =

Call
.252515

Put

-.221559
Rho is in terms of $/%change of r.
(check on computer)
16

DELTA-NEUTRAL POSITIONS
A market maker wrote n(c) calls and
wishes to protect the revenue against
possible adverse move of the
underlying asset price. To do so,
he/she uses shares of the underlying
asset in a quantity that GUARANTEES
that a small price change will not have
any impact on the call-shares position.
Definition: A portfolio is Delta-neutral
if
17

DELTA neutral position in the simple

case of call-stock portfolios.
Vportfolio = Sn(S) + cn(c;S)
(portfolio) = (S)n(S) + (c)n(c;S)
(portfolio) = 0 n(S) + (c)n(c;S) = 0.
n(S) = - n(c;S)(c).
The call delta is positive. Thus, the
negative sign indicates that the calls
and the shares of the underlying asset
must be held in opposite direction.
18

EXAMPLE: call - stock portfolio

We just sold 10 CBOE calls whose
delta is $.54/shares. Each call covers
100 shares.
n(S) = - n(c;S)(c).
(c) = 0.54 and n(c) = -10.
n(c;S) = - 1,000 shares.
n(s)

= - [ - 1,000(0.54)] = 540.

The DELTA-neutral position consists of

the 10 short calls and 540 long shares.
19

The Hedge Ratio c

Definition: Hedge ratio.
Hedge Ratio
The number of shares required to neutralize the portfolio

The number of shares covered by the options

In the example:
Hedge ratio = 540/1,000 = .54
Notice that this is nothing other than
(c).
20

In the numerical example, Slide 9:

The hedge ratio:

(c) = 0.6151

With 100 CBOE short calls:

n(S) = -(c)n(c;S).
n(c;S) = -10,000.
n(S) = -(.6151)[-10,000] = +6,151
shares The value of this portfolio is:
V = -10,000($10.3044) +
6,151($100)
V = $512,056

21

Suppose that the stock price rises

by $1.
SNEW = 100 + 1 = $101/share.
V = - 10,000($10.3044 + $.6151)
+6,151($101)
V = - 10,000($10.3044) +
6,151($100)
- 10,000($.6151) + $1(6,151)
V = $512,056 - $6,151 + $6,151

22

Suppose that the stock price falls

by $1.
SNEW = 100 - 1 = $99/share.
V = - 10,000($10.3044 - $.6151)
+6,151($99)
V = - 10,000($10.3044) +
6,151($100)
- 10,000( - $.6151) - $1(6,151)
V = $512,056 + $6,151 $6,151

23

In summary:
The portfolio consisting of 100 short
calls and 6,151 long shares is

delta- neutral.
Price/share:
shares
$6,151
calls
$6,151)
Portfolio

+$1

+$6,151

-$1
-

+(-$6,151) -($0

24
$0

DELTA neutral position in the simple

case of put-stock portfolios.
Vportfolio = Sn(S) + pn(p;S)
(portfolio) = (S)n(S) + (p)n(p;S)
(portfolio) = 0 n(S) + (p)n(p;S) =
0.
n(S) = - n(p;S)(p)
Since the put delta is negative, then
the negative sign indicates that the
puts and the underlying asset must be
25
held in the same direction.

EXAMPLE: put stock portfolio.

We just bought 10 CBOE puts whose
delta is -$.70/share. Each put covers
100 shares.
n(S) = n(p;S)(p).
(p) = -.70 and n(p) = 10.
n(p;S) = 1,000 shares.
n(S)

= - 1,000(-.70) = 700.

The DELTA-neutral position consists of

the 10 long puts and 700 long shares.
26

Portfolio: The portfolio consisting of

10 long puts and 700 long shares is

delta- neutral.
Price/share:
shares
puts
Portfolio

+$1

+$700

-$1
-$700

-$700
$0

$700
$0

27

In the numerical example, Slide 9:

The hedge ratio:

(p) = -0.3849

The Delta neutral position with 100

CBOE long puts requires the holding
of:
n(S) = -(p)n(p;S)
n(S) = -(-.3849)[10,000] =
+3,849shares The value of this
portfolio is:
V = 10,000($6.4360) +
3,849($100)

28

Suppose that the stock price rises

by $1.
SNEW = 100 + 1 = $101/share.
V = 10,000($6.4360 - .3849)
+3,849($101)
V = 10,000( $6.4360) 3,849($100)
- 10,000(.3849) + $1(3,849)
V = $449,260- $3,849 + $3,849

29

Suppose that the stock price falls

by $1.
SNEW = 100 - 1 = $99/share.
V = 10,000($6.4360 + $.3849)
+3,849($99)
V = 10,000( $6.4360) + 3,849($100)
10,000($.3849) - $1(3,849)
V = $449,260+ $3,849 - $3,849
V = $449,260.

30

In summary:
The portfolio consisting of 100 long
puts and 6,151 long shares is

delta- neutral.
Price/share:
shares
$3,849
calls
$3,849)
Portfolio

+$1

+$3,849

-$1
-

+(-$3,849) -($0

31
$0

An extension:

calls, puts and the stock positio

Vportfolio = Sn(S) + cn(c;S) + pn(p;S)
portfolio = (S)n(S) + (c)n(c;S) +
(p)n(p;S).
But S = 1.
Thus, for delta-neutral portfolio:
portfolio = 0 and
32

EXAMPLE: We short 20 calls and 20

puts whose deltas are $.7/share and $.3/share, respectively. Every call and
every put covers 100 shares.
How many shares of the underlying
stock we must purchase in order to
create a delta-neutral position?
n(S) = -(c)n(c;S) + [-(p)]n(p;S).
n(S) = -(.7)(-2,000) [-.3](-2,000)
n(S) = 800.
33

Example continued
The portfolio consisting of 20 short
calls, 20 short puts and 800 long
shares is
delta- neutral.
Price/share:
shares
calls
$1,400
Puts

+$1

+$800

-$1
-$800

-$1,400

+$600

-$600
34

EXAMPLES
The put-call parity:
Long 100 shares of the underlying
stock,
long one put and short one call on this
stock is always delta-neutral:
(position)
= 100 + (p)n(p;S) + (c)n(c;S)
35
= 100 + [(c) 1](100) + (c)(-100)

EXAMPLES
A long STRADDLE:
Long 15 puts and long 15 calls
(same underlying asset, K and T-t),
with:

(c) = .64;

(p) = - .36.

(straddle) = 15(100)[.64 + (- .
36)]
=$420/share.
36
Long 420 shares to delta neutralize

Results:
1.The deltas of a call and a put on the
same underlying asset, (with the
same time to expiration and the
same exercise price) must satisfy
the following equality:
(p) = (c) - 1
2. Using the Black and Scholes
formula:
(c) = N(d1)

0 < (c) < 1

37

38

39

40

41

THETA

Theta measures the sensitivity of the

options price to a small change in
the time remaining to expiration:
(c) = c/(T-t)
(p)= p/(T-t)
Theta is given in terms is $/1 year.
Thus, if (c) = - $20/year, it means that
if time to expiration increases
(decreases) by one year, the call price
42
will increase (decreases) by $20. Or,

43

44

45

46

GAMMA
Gamma measures the change in delta
when the market price of the
underlying asset changes.
(c) = (c)/S = 2c/ S2
(p) = (p)/S = 2p/ S2
Results:
(c) = (p)
(S) = 0.
47

GAMMA
In general, the Gamma of any portfolio
is the change of the portfolios delta
due to a small change in the
underlying asset price.
As the second derivative of the
options price with respect to S,
Gamma measures the sensitivity of
the options price to large
underlying assets price changes.
May be positive or negative.
48

Interpretation of Gamma
The delta neutral position with 100
short calls and 6,151 long shares has
= -$181
Position
value

$512,056

75

More negative

100

125

Negative Gamma means that the

position loses value when the stock
price moves more and more away from
49

Interpretation of Gamma

Positive
Gamma

Negative Gamma
50

Result: The Gammas of a put and a

call are equal. Using the Black and
Shcoles model:
(c) = n(d1) and (p) = n(d1) 1.
Clearly, the derivatives of these
deltas with respect to S are equal.
EXAMPLE:

(c) = .70; (p) = - .30;

= .2345.

Holding a long call and a short put

has:
= .70 - (- .30) = 1.00.
51

EXAMPLE:
(c) = .70, (p) = - .30 and let gamma be .
2345.
Holding the underlying asset long, a long put
and a short call yields a portfolio with:
= 1 - .70 + (- .30) = 0 and
= 0 - 0,2345 + 0,2345 = 0,
simultaneously! This portfolio is

delta-gamma-neutral.

52

53

54

55

VEGA

Vega measures the sensitivity of the options

market price to small changes in the
volatility of the underlying assets return.
(c) = c/

(p) = p/
Thus, Vega is in terms of $/1% change in
56

57

58

59

60

RHO

Rho measures the sensitivity of the options

price to small changes in the rate of interest.
(c) = c/r

(p) =

p/r

Rho is in terms of $/%change of r.

61

62

63

64

65

SUMMERY OF THE GREEKS

Position
Rho
LONG STOCK
0

Delta Gamma

Vega

Theta

SHORT STOCK -1
0

LONG CALL
+

SHORT CALL
-

+
66

The sensitivity of portfolios, a

summary.
1.A portfolio is a combination of
securities and options.
2.All the sensitivity measures are
partial derivatives.
3.Theorem(Calculus): The derivative
of a linear combination of functions
is the combination of the derivatives
of these functions. Thus, the
sensitivity measure of a portfolio of
67
securities is the portfolio of these

Example:The DELTA of a portfolio of 5

long CBOE calls, 5 short puts and 100
shares of the stock long:
(portfolio)
100S)

= (500c - 500p +
= (500c - 500p + 100S)/S
= 500c/S - 500p/S +

100
= 500c - 500p + 100
This delta reveals the $/share change
in the portfolio value as a function68 of

Example:

S = $48.57/barrel.

1 call = 1,000bbls.
Call

Delta

Gamma

$0.63/bbl

$0.22/bbl

$0.45/bbl

$0.34/bbl

$0.82/bbl

$0.18/bbl

Portfolio:
Long: 3 calls A; 2 calls C; 5,000
barrels. Short: 10 calls B.

69

Example:
=

(0.63)3,000+ (0.82)2,000
+ (1)5,000 + (0.45)(-10,000)

(0.22)3,000+ (0.18)2,000
+ (0)5,000 + (0.34)(-10,000)

$4,030.

- $2,380.
70

 = 4,030 a small change of the

oil price, say one cent per barrel, will
change the value of the above
portfolio by $40.30 in the same
direction.
= - 2,380 a small change in the
oil price, say one cent per barrel, will
change the delta by $23.80 in the
opposite direction.
Also, Gamma is negative when the
price per barrel moves away from
$48.57, the portfolio value will 71

A financial institution holds:

5,000 CBOE calls long; delta .4,
6,000 CBOE puts long;

delta

10,000 CBOE puts short;

delta

-.7,
-.5,
Long 100,000 shares
(portfolio) = (.4)500,000 +
(-.7)600,000
+(-.5)[-1,000,000]

72

GREEKS BASED STRATEGIES

Greeks based strategies are opened
and maintained in order to attain
a specific level of sensitivity.
Mostly, these strategies are set
to attain zero sensitivity. What
follows, is an example of
strategies that are:
1.Delta-neutral
2.Delta-Gamma-neutral
3.Delta-Gamma-Vega-Rho-neutral73

EXAMPLE:
The underlying asset is the a stock.
The options on this stock are
European.
S = $300; K = $300; T = 1yr; =
18%; r = 8%; q = 3%.
c = $28.25.
= .6245
= .0067
= .0109

74

DELTA-NEUTRAL
Short 100 calls. n0 = - 10,000; Long nS = 6,245
shares
Case A1:
$301.
Portfolio

S increases from $300 to

Initial Value

-100Calls - $282,500
- $6,300
6,245S

$1,873,500

New value

Change

- $288,800
$1,879,745

$6,245

Error:

$55
Case A2:
$299.

S decreases from $300 to

75

Case B1:
$310.
Portfolio

S increases from $300 to

Initial Value

-100Calls - $282,500
- $65,600
6,245S

$1,873,500

New value

Change

- $348,100
$1,935,950

$62,450

Error:

$3,150
The point here is that Delta has changed
significantly and .6245 does not apply any more.
S = $300
=

.6245

$301

$310
.6311

.6879.

We conclude that the delta-neutral portfolio must

76

Call #0

Call #1

S = $300

S = $300

K = $300

K = $305

T = 1yr

T = 90 days

= 18% r = 8% q = 3%
c = $28.25

c = $10.02

= .6245

= .4952

= .0067

= .0148

= .0109

= .0059

= .0159

= .0034

77

A DELTA-GAMMA-NEUTRAL PORTFOILO
(portfolio) = 0: nS + n0(.6245) + n1(.4952) = 0
(portfolio)= 0:

n0(.0067) + n1(.0148) = 0

Solution:
n0 = -10,000
n1 = - (-10,000)(.0067)/.0148 = 4,527
nS = - (-10,000)(.6245) (4,527)(.4952) = 4,003
Short the initial call :

n0 = -10,000

Long 45.27 of call #1

n1 = 4,527
78

THE DELTA-GAMMA-NEUTRAL PORTFOLIO

Case A1:
Portfolio

S increases from $300 to $301.

Initial value

0) -10,000

New value

Change

- $282,500

- $288,800

-$6,300

$47,657

$2,297

1)

4,527

$45,360

S)

4,003

$1,200,900

$1,204,903
Error:

Case B1:
Portfolio

$4,003
0

S increases from $300 to $310.

Initial value

0) -10,000- $282,500
1) 4,527
$25,570

$45,360

S) 4,003

$1,200,900

New value

Change

- $348,100

- $65,600

$70,930
$1,240,930

$40,030
Error:

79

If we examine the exposure level to all parameters,

however, we observe that:
Portfolio

Delta

-10,000

- 6,245

- 67

- 109

- 159

4,527

2,242

67

27

15

4,003S

4,003

- 82

Risk

Gamma

Vega

Rho

- 144

The above numbers reveal that the DeltaGamma-neutral portfolio is exposed to risk
associated with
the volatility and the risk-free rate

80

Case C1:
S increases from $300 to $310
and simultaneously,
r increases from 8% to 9%.
Portfolio Initial value

New value

Change

-10,000

- $282,500

- $330,500

- $48,000

4,527

$45,360

$73,166

$27,806

$1,240,930

$40,030

4,003S

$1,200,900

Error: - $10,756
81

Delta-Gamma-Vega-Rho-neutral
portfolio
CALL

300

305

295

300

T(days)

365

90

90

180

Volatility

18%

18%

18%

18%

8%

8%

8%

8%

Dividends

3%

3%

3%

3%

$28.25 $10.02 $15.29

$18.59
82

Delta-Gamma-Vega-Rho-neutral portfolio
CALL

.6245

.0067

.0109

.0159

.4954

.0148

.0059

.0034

.6398

.0138

.0055

.0044

.5931

.0100

.0080

.0079

1.0

0.0

0.0

0.0
83

The DELTA-GAMMA-VEGA-RHONEUTRAL-PORTFOLIO
In order to neutralize the portfolio to
all risk exposures, following the sale
of the initial call, we now determine
the portfolios holdings such that all
the portfolios sensitivity parameters
are zero simultaneously.
= 0 and = 0 and = 0 and =
0
simultaneously!
84

=0
nS+n0(.6245)+n1(.4954)+n2(.6398)+n3(.5931)
=0

=0
n0(.0067)+n1(.0148)+n2(.0138)+n3(.0100)
=0

=0
n0(.0109)+n1(.0059)+n2(.0055)+n3(.0080)
85
=0

The solution is:

Exact n
Short 100 CBOE calls #0;

-10,000

Short 339 calls #1;

-33,927

Long 265 calls #2;

26,534

Long 204 calls #3;

20,420

Short 6,234 shares.

-6,234
86

Case D: S increases from $300 to $310

r increases from 8% to 9%
increases from 18%
to 24%
Portfolio
New value
0) - 10,000
S) - 6,234

Initial Value
- $282,468

- $1,870,200

1) - 33,927

- $340,023

2) 26,534
$694,062

$405,668

- $428,071
- $1,932,540
- $664,552
87

DYNAMIC DELTA - HEDGING

The market stock price keeps
changing all
the time. Thus, a static DELTA- neutral
hedge is not sufficient.
A continuous delta adjustment is not
practical.
An adjusted Delta-neutral Position:
1.Every day, week, etc.
88

DYNAMIC DELTA HEDGING

Market makers provide traders with
the options they wish to trade. For
example, if a trader wishes to long
(short) a call, a market maker will
write (long) the call. The difference
between the buy and sell prices is
the market makers

bid-ask spread.
The main problem for a market maker
who shorts calls is that the premium
89
received, not only may be lost, but

DYNAMIC DELTA - HEDGING

Recall: The profit profile of an
uncovered call is:
P/L

At expiration

c
K

ST

90

DYNAMIC DELTA - HEDGING

Recall: The profit profile of a
covered call
is:
Strategy

IFC

Short
call
Long
stock
Total

-(ST K)

-St

ST

ST

ST

ST - St +

K - St91+

P/L

- St + c

At expiration
ST < K
ST > K

DYNAMIC DELTA - HEDGING

Recall: The profit profile of a covered
call is:
P/L

At expiration

K St+ c
K

-St + c

ST

92

DYNAMIC DELTA - HEDGING

The Dynamic Delta hedge is based on
the
impact of the time decay on the call
2
t
Delta.

S
ln[ ] [r .5 ][T t]
K
Recalldthat:

1
Tt
and
N(d1 ) (c)

93

DYNAMIC DELTA - HEDGING

Observe what happens to d1
when T-t 0.
1.

For:St > K

d1

and

N(d1) = (c) 1
2.

For:St < K

d1 -

and

N(d1) = (c) 0
94

DYNAMIC DELTA - HEDGING

The Dynamic hedge:
1.Write a call and simultaneously,
hedge the call by a long Delta
shares of the underlying asset. As
time goes by, adjust the number of
shares periodically.
Result: As the expiration date nears,
delta:
goes to 0

in which case you wind

up without any shares.
95

DYNAMIC DELTA - HEDGING

St :
(c):
Call:
n(S):

St < K
0

St > K
1

uncovered fully covered

0

n(c;S) 1

96

Table 15.2 Simulation of Dynamic delta - hedging.(p.364)

Stock
Interest
Week przce
0
1
2
3
4
5
6
7
8
9

($000)
49.00
48.12
2.2
47.37
1.9
50.25
2.9
51.75
3.3
53.12
3.8
53.00
3.7
51.87
3.4
51.38
3.3
53.00
3.8

Cost of
shares

Cummulative

purchased

purchased
($000)

cost
($000)

0.522
2.5
0.458

52,200

2,557.8

(6,400)

(308.0)

2,252.3

0.400

(5,800)

(274.7)

1,979.8

0.596

19,600

984.9

2,966.6

0.693

9,700

502.0

3,471.5

0.774

8,100

430.3

3,905.1

0.771

(300)

(15.9)

3,893.0

0.706

(6,500)

(337.2)

3,559.5

0.674

(3,200)

(164.4)

3,398.5

0.787

11,300

598.9

4,000.7

Shares
Delta

cost
2,557.8

97

Table 15.3 Simulation of dynamic Delta - hedging. (p. 365)

Stock
nterest
Week
price
0

Shares
Delta

purchased

Cost of
shares
purchased
($000)
2,557.8
0.568 4,600
2

Cumulative

cost
($000)

cost
($000)

49,00 0.522 52,200

557.8
2.5
1
49.75
228.9
2,789.2
2.7
52.00 0.705
13,700
712.4
3,504.3
3.4
3
50.00
0.579
(12,600)
(630.0)
2,877.7
2.8
4
48.38 0.459 (12,000)
(580.6)
2,299.9
2.2
5
48.25 0.443 (1,600)
(77.2)
2,224.9
2.1
6
48.75 0.475 3,200
156.0
2,383.0
2.3
7
49.63 0.540 6,500
322.6
2,707.9
2.6
8
48.25 0.420
(12,000)
(579.0)
2,131.5
2.1
9
48.25 0.410 (1,000)
(48.2)
2,085.4
2.0 10
51.12 0.658 24,800
1,267.8
3,355.2
3.2 11
51.50 0.692 3,400
175.1
3,533.5
3.4
12
49.88 0.542
(15,000)
(748.2)
2,788.7
2.7 13
49.88 0.538 (400)
(20.0)
2,771.4
2.7 14
48.75 0.400
(13,800)
(672.7)
2,101.4
2.0 15
47.50 0.236 (16,400)
(779.0)
1,324.4
1.3 16
48.00 0.261 2,500
9846.25
120.0
1,445.7
1.4 17