28-11-2020

The Greek Letters

Sankarshan Basu
Professor of Finance
Indian Institute of Management Bangalore

Option Portfolio Value and

Greeks

Option portfolio value,   fn (s, t, r, )

Using Taylor series expansion,
    1  2
Δ  * Δs  * Δt  * Δr  * Δσ  * 2 * Δs 2     
s t r σ 2 s
1
 Δ * Δs  Θ * Δt  ρ * Δr  ν * Δσ  * Γ * Δs 2
2

Delta
• Delta (D) is the rate of change of the option price with
respect to the underlying.
• If c is the price of the call option and S is the stock price,
c
then, D 
S
Option
price

Slope = D
B

A Stock price

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Delta
• Delta denotes the movement of the option position
relative to the movement of the underlying
position. So, Delta is the speed of change of option
value when underlying asset value changes.
• Delta is another way of expressing the probability
of an option expiring in the money.
• ATM call options have a Delta of 0.5 or 50%
meaning a 50% chance of expiring ITM.
• Deep ITM call will have a Delta of 1 meaning a
100% chance of expiring ITM.
• Deep OTM call will have a Delta close to zero
meaning a near zero chance of expiring ITM.
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Delta
Delta Range
Long call 0 to 1.00 Short call 0 to -1.00
Long put 0 to -1.00 Short put 0 to 1.00
Delta Range Rules of Thumb (Long Call)
Deep-in-the-money 0.75 to 1.00
Slightly-in-the-money 0.55 to 0.75
At-the-money 0.45 to 0.55
Slightly-out-of-the-money 0.25 to 0.45
Deep-out-of-the-money 0 to 0.25
Delta of long stock is 1 and -1 for short stock.

Delta of European Options

• The delta for a European call on a non-
dividend paying stock D = N (d 1)
• The delta for a European put on a non-
dividend paying stock D = N (d 1) – 1
• The delta of a European call on a asst
paying dividends at rate q is N (d 1)e– qT
• The delta of a European put on this asset
is e– qT [N (d 1) – 1]

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Position Delta
• Position Delta or Delta of a portfolio of options or
other derivatives dependent on a single asset whose
price is S and the value of the portfolio is Π is

D
S
• The delta of the portfolio can be calculated from the
deltas of the individual options in the portfolio.
• If a portfolio consists of a quantity wi of option i (1 < i <
n), the Position Delta is
n
D   wi D i
i 1
• where ∆i is the delta of ith option.

Delta of a Portfolio – Example

• Suppose a financial institution in the United States has
the following three positions in options on the Australian
dollar:
1. A long position in 100,000 call options with strike price 0.55
and an expiration date in three months.
– The delta of each option is 0.533.
2. A short position in 200,000 call options with strike price 0.56
and an expiration date in five months.
– The delta of each option is 0.468.
3. A short position in 50,000 put options with strike price 0.56 and
an expiration date in two months.
– The delta of each option is – 0.508.
• The delta of the whole portfolio is
= 100,000*0.533 – 200,000*0.468 – 50,000*(– 0.508)
= – 14,900
• This means that the portfolio can be made delta neutral
with a long position of 14,900 Australian dollars.
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Delta – Hedging Schemes

• A position with a delta of zero is referred to as
being delta neutral.
• Because delta changes, the investor's position
remains delta hedged (or delta neutral) only for
a relatively short period of time. The hedge has
to be adjusted periodically. This is known as
rebalancing.
• The delta-hedging scheme with intermediate
adjustment is called dynamic-hedging
scheme.

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Using Futures for Delta Hedging

• The delta of a futures contract is e(r-q)T
times the delta of a spot contract.
• The position required in futures for delta
hedging is therefore e-(r-q)T times the
position required in the corresponding
spot contract.

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Gamma
• Gamma (G) is the rate of change of delta (D) with
respect to the price of the underlying asset.
D  2
G 
S S 2

• If gamma is small, delta changes slowly, and

adjustments to keep a portfolio delta neutral need to be
made only relatively infrequently.
• If gamma is large in absolute terms, delta is highly
sensitive to the price of the underlying asset.

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Gamma
• Gamma can be viewed in two ways.
a) as the acceleration of the option position relative to
the underlying stock price.
b) as the odds of a change in Delta.
• Gamma is effectively an early warning that Delta could
be about to change.
• Both calls and puts have positive Gammas.
• Deep OTM and deep ITM options have near zero
Gamma because the odds of a change of delta are very
low.
• Logically Gamma tends to peak around the strike price.

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Gamma as Curvature in Option Price

Call
price

C''
C'

C
Stock price
S S'
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Making a Portfolio Gamma Neutral

• Making a delta-neutral portfolio gamma
neutral can be regarded as a first correction for
the fact that the position in the underlying asset
cannot be changed continuously when delta
hedging is used. An option on the underlying
asset is used for this purpose. The underlying
asset cannot be used because its gamma is zero.
• Delta neutrality provides protection against
relatively small stock price moves between
rebalancing.
• Gamma neutrality provides protection against
larger movements in the stock price between
hedge rebalancing.
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Making a Portfolio Gamma Neutral

– Example
• Suppose that a portfolio is delta neutral and has a
gamma of -3,000.
• The delta and gamma of a particular traded call option
are 0.62 and 1.50, respectively.
• The portfolio can be made gamma neutral by including
in the portfolio a long position of (3,000/1.5) =
2,000 in the call option.
• However, the delta of the portfolio will then change from
zero to 2,000*0.62 = 1,240.
• A quantity 1,240 of the underlying asset must
therefore be sold from the portfolio to keep it delta
neutral.

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Calculation of Gamma
For a European call or put on non - dividend paying stock :
N ' ( d1 )
G
S0 T
ln(S 0 / K )  (r   2 / 2)T
where d1 
 T
For a European call or put on asset paying dividend at rate q :
N ' (d1 )e qT
G
S 0 T
ln(S 0 / K )  (r  q   2 / 2)T
where d1 
 T
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Gamma – Example
• Consider a four-month put option on a stock index. The
current value of the index is 305, the strike price is 300,
the dividend yield is 3% per annum, the risk-free interest
rate is 8% per annum, and volatility of the index is 25%
per annum.
• In this case, So = 305, K = 300, q = 0.03, r = 0.08, σ =
0.25, and T = 4/12.
• The gamma of the index option is given by
N ' (d1)eqT
 =0.00857
S0 T
• Thus, an increase of 1 in the index (from 305 to
306) increases the delta of the option by
approximately 0.00857.

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Interpretation of Gamma
• For a delta neutral portfolio,
D  Q Dt + ½GDS 2

D D

DS
DS

Slightly Positive Gamma Slightly Negative Gamma

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Interpretation of Gamma – contd.

D D

DS
DS

Large Positive Gamma Large Negative Gamma

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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.
f
θ of a call or put 
t
• Theta stands for the option position’s sensitivity to time
decay.
• Long (Short) options have negative (positive) Theta
meaning that time decay is eroding the time value portion
of the option value as days pass.
• Time decay thus hurts an option buyer and helps option
writer’s position.

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Theta for NDPS European Calls and Puts

For a European call on non - dividend paying stock :

S 0 N ' (d1 )
Q(call)    rKe  rT N (d 2 )
2 T
For a European put on non - dividend paying stock :
S N ' (d1 )
Q(put)   0  rKe  rT N ( d 2 )
2 T
ln( S0 / K )  (r   2 / 2)T
where d1 
 T
ln( S0 / K )  (r   2 / 2)T
d2   d1   T
 T
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Theta for DPS European Calls and Puts

For a European call on asset paying dividend at rate q :
S 0 N ' ( d1 )e qT
Q(call)    qS0 N ( d1 )e  qT  rKe  rT N ( d 2 )
2 T
For a European put on asset paying dividend at rate q :
S 0 N ' ( d1 )e qT
Q(put)    qS0 N (  d1 )e  qT  rKe  rT N (  d 2 )
2 T
ln( S / K )  ( r  q   2 / 2)T
0
where d1 
 T
ln( S 0 / K )  (r  q   2 / 2)T
d2   d1   T
 T
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Theta – Example
• Consider a four-month put option on a stock index. The
current value of the index is 305, the strike price is 300,
the dividend yield is 3% per annum, the risk-free interest
rate is 8% per annum, and the volatility of the index is
25% per annum.
• In this case So = 305, K = 300, q = 0.03, r = 0.08, σ = 0.25, and T =
0.3333.
• The option's theta is
S 0 N ' ( d1 )e  qT
  qS 0 N ( d1 )e  qT  rKe  rT N (  d 2 )
2 T
= – 18.15
= – 18.15/365 = -0.0497 per calendar day
= – 18.15/252 = -0.0720 per trading day
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Relationship Between Delta,

Gamma, and Theta
Portfolio value  satisfies the differenti al equation :
  1 2 2  2 
 rS   S  r
t S 2 S 2
   2
But, Q  ; D; G
t S S 2
1 2 2
Hence, Q  rS D   S G  r
2
For D neutral portfolio,
1
Q   2 S 2 G  r
2

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Relationship Between Delta,

Gamma, and Theta – With Dividend
For a portfolio of derivatives on a stock
paying a continuous dividend yield at
rate q

1
Q  (r  q ) SD   2 S 2 G  r
2

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Vega
• Vega (n) is the rate of change of the value of a
derivatives portfolio with respect to volatility.

n 

• Options tend to increase in value when the underlying
asset’s volatility increases.
• Volatility helps the option buyers and hurts the writers.
• Vega is positive for long options and negative for short
options.
• Vega tends to be greatest for options that are close to at-
the-money.
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Calculation of Vega
For a European call or put on non - dividend paying stock :
n  S 0 T N ' (d1 )
ln( S0 / K )  (r   2 / 2)T
where d1 
 T
For a European call or put on asset paying dividend at rate q :
n  S0 T N ' (d1 )e qT
ln( S0 / K )  (r  q   2 / 2)T
where d1 
 T

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Managing Delta, Gamma, & Vega

• Delta (D) can be changed by taking a position in
the underlying.
• To adjust G & n it is necessary to take a position
in an option or other derivative.

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Rho
• Rho is the rate of change of the value of a
derivative with respect to the interest rate.

rho 
r
• For currency options there are 2 rhos
corresponding to two interest rates.
For European options on non - dividend paying stocks,
rho(call)  KTe - rt N(d 2 ) and
rho(put)  - KTe - rt N(-d 2 )

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Rho
• Rho stands for the option position’s
sensitivity to interest rates.
• A positive Rho means that higher interest
rates are helping the position and a negative
Rho means that higher interest rates are
hurting the position.
• Rho is the least important of all the Greeks
as far as stock options are concerned.

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Positive or Negative Sign of Greeks

• A plus or minus sign for a Greek is based
on the assumption that the underlying
stock price rises, time is moving forward,
volatility and interest arte are increasing.
• A Greek can be positive or negative
number , depending on long or short
option and whether it is a call or put.

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Positive or Negative Sign of Greeks

Option Delta Gamma Vega Theta
Long call + + + -
Short call - - - +

Long put - + + -
Short put + - - +

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Hedging Principle
n
For D  neutrality, D p   wi D i  0
i 1
n
For G  neutrality, Gp   wi Gi  0
i 1
n
For n  neutrality,n p   win i  0
i 1
n
For self - financing at date 0,  wi Valuei  0
i 1

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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.
• As portfolio becomes larger hedging
becomes less expensive.

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Problem No. 1
• A financial institution has just sold 1,000 seven-
month European call options on the Japanese
yen. Suppose that the spot exchange rate is 0.80
cents per yen, the exercise price is 0.81 cents per
yen, the risk-free interest rate in the United
States is 8% per annum, the risk-free interest
rate in Japan is 5% per annum, and the volatility
of the yen is 15% per annum. Calculate the delta,
gamma, vega, theta, and rho of the financial
institution's position. Interpret each number.
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Problem No. 1 (Ans.)

In this case,
S0  0.80, K  0.81, r  0.08, rf  0.05,   0.15 and T  0.5833
ln(0.80 / 0.81)  (0.08  0.05  0.152 / 2)  0.5833
d1   0.1016
0.15 0.5833
d 2  d1  0.15 0.5833  0.0130
N (d1 )  0.5405; N (d 2 )  0.4998
The delta of one call option is e rf N (d1 )  e 0.05*0.5833 * 0.5405
 0.5250.
1 d12 / 2 1 0.00516
N ' (d1 )  e  e  0.3969
2 2

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Problem No. 1 (Ans. – contd.)

Hence, gamma of one call option is
N ' (d1 )e rf T 0.3969 * 0.9713
  4.206
S T 0.80 * 0.15 * 0.5833
The vega of one call option is
S0 T N ' (d1 )e rf T  0.80 0.5833 * 0.3969 * 0.9713  0.2355
The theta of one call option is
S0 T N ' (d1 )e rf T
  rf S0 N (d1 )e rf T  rKe rT N (d 2 )
2 T
0.8 * 0.3969 * 0.15 * 0.9713

2 * 0.5833
 0.05 * 0.8 * 0.5405 * 0.9713  0.08 * 0.81* 0.9544 * 0.4948  0.3933
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Problem No. 1 (Ans. – contd.)

The rho of one call option is
 KT e N ( d )  0 .81 * 0 .5833 * 0 . 9544 * 0 .4948
 rT
2

 0 .2231
Interpreta tion of Delta : When the spot price increases
by a small amount (measured in cents), the value of an
option to buy one yen increases by 0.525 times that
amount.
Interpreta tion of Gamma : When the spot price increases
by a small amount (measured in cents), the delta
increases by 4.206 times that amount.
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Problem No. 1 (Ans. – contd.)

Interpretation of Vega : When the volatilit y (measured in
decimal form), increases by a small amount, the option' s
value increases by 0.2355 times that amount.
Interpretation of Theta : When a small amount of time
(measured in years) passes, the option' s value decreases
by 0.3933 times that amount.
Interpretation of Rho : When the interest rate (measured
in decimal form), increases by a small amount, the
option' s value increases by 0.2231 times that amount.

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Problem No. 2
• A bank's position in options on the dollar-euro
exchange rate has a delta of 30,000 and a
gamma of -80,000. Explain how these numbers
can be interpreted. The exchange rate (dollars
per euro) is 0.90. What position would you take
to make the position delta neutral? After a short
period of time, the exchange rate moves to 0.93.
Estimate the new delta. What additional trade is
necessary to keep the position delta neutral?
Assuming the bank did set up a delta-neutral
position originally, has it gained or lost money
from the exchange rate movement?

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Problem No. 2 (Ans.)

• The delta indicates that when the value of the euro
exchange rate increases by $0.01, the value of the bank’s
position increases by 0.01*30,000= $300.
• The gamma indicates that when the value of the euro
exchange rate increases by $0.01, the delta of the
portfolio decreases by 0.01*80,000= $800.
• For delta neutrality 30,000 euros should be shorted.
• When the exchange rate moves up to 0.93, we expect the
delta of the portfolio to decrease by (0.93 –
0.90)*80,000 = 2,400 so that it becomes 27,600.
• To maintain delta neutrality, it is therefore necessary for
the bank to unwind its short position 2,400 euros so that
a net 27,600 has been shorted.

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Problem No. 2 (Ans. – contd.)

• As shown in the figure below, when a portfolio is delta
neutral and has a negative gamma, a loss is experienced
when there is a large movement in the underlying asset
price. We can conclude that the bank is likely to have lost
money.
D D

DS DS

Slightly Negative Gamma Large Negative Gamma

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Problem No. 3
• A financial institution has the following portfolio of over-the-
counter options on sterling:
Type Position Delta of option Gamma of option Vega of option
Call -1,000 0.5 2.2 1.8
Call -500 0.8 0.6 0.2
Put -2,000 -0.4 1.3 0.7
Call -500 0.7 1.8 1.4
• A traded option is available with a delta of 0.6, a gamma of 1.5, and a
vega of 0.8.
a. What position in the traded option and in sterling would make the
portfolio both gamma neutral and delta neutral?
b. What position in the traded option and in sterling would make the
portfolio both vega neutral and delta neutral?

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Problem No. 3 (Ans.)

• The delta of the portfolio
= – 1,000*0.50 – 500*0.8 – 2,000*(–0.40) – 500*0.70
= – 450
• The gamma of the portfolio
= – 1,000*2.2 – 500*0.6 – 2,000*(1.3) – 500*1.8
= – 6,000
• The vega of the portfolio
= – 1,000*1.8 – 500*0.2 – 2,000*0.7 – 500*1.4
= – 4,000
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Problem No. 3 (Ans. – contd.)

Part a:
• A long position in 4,000 traded option will give a
gamma-neutral portfolio since the long position
has a gamma of 4,000*1.5 = 6,000.
• The delta value of the whole portfolio (including
traded options) is then
= 4,000*0.6 – 450 = 1,950
• Hence in addition to the 4,000 traded options, a
short position in £1,950 is necessary so that the
portfolio is both gamma and delta neutral.

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Problem No. 3 (Ans. – contd.)

Part b:
• A long position in 5,000 traded option will give a vega-
neutral portfolio since the long position has a vega of
5,000*0.8 = 4,000.
• The delta value of the whole portfolio (including traded
options) is then
= 5,000*0.6 – 450 = 2,550
• Hence in addition to the 5,000 traded options, a short
position in £2,550 is necessary so that the portfolio is
both vega and delta neutral.

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