Options, Futures, and Other Derivatives
Tenth Edition
Chapter 19
The Greek Letters
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
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%
• The Black-Scholes-Merton value of the option is $240,000
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Naked and Covered Positions
• Naked position
– Take no action
• Covered position
– Buy 100,000 shares today
• What are the risks associated with these strategies?
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Stop-Loss Strategy (1 of 2)
• This involves:
– Buying 100,000 shares as soon as price rises above $50
– Selling 100,000 shares as soon as price falls below $50
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Stop-Loss Strategy (2 of 2)
Ignoring discounting, the cost of writing and hedging the option
appears to be max(S0−K, 0). What are we overlooking?
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
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
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
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
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
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
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
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= -N(-d 1)
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Delta of a Stock Option (K = 50, r = 0, s = 25%,
T = 2)
Call Put
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
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
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
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
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
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
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Gamma Addresses Delta Hedging Errors
Caused By Curvature
Call
price
C''
C'
C
Stock price
S S'
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Gamma for Call or Put Option: (K=50, s =
25%, r = 0%, T = 2)
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
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
rS S r
2
What if delta is zero?
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Vega
• Vega (n) is the rate of change of the value of a derivatives portfolio
with respect to volatility (usually implied 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
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Vega for Call or Put Option
(K = 50,s = 25%, r = 0, T = 2)
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Managing Delta, Gamma, and 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
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Example (1 of 2)
Blank 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.
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Example (2 of 2)
Blank 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.
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Rho
• Rho is the rate of change of the value of a derivative with respect to
the interest rate
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Hedging in Practice
• Traders usually ensure that their portfolios are delta-neutral at least
once a day
• Whenever the opportunity arises, they improve gamma and Vega
• There are economies of scale
– As portfolio becomes larger hedging becomes less expensive
per option in the portfolio
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Scenario Analysis
A scenario analysis involves testing the effect on the value of a
portfolio of different assumptions concerning asset prices and their
volatilities
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
