2015

OPTION GREEKS

OPTIONS PRIMER - 2
Contents
OPTION GREEKS ................................................................................................................................ 3
DELTA ................................................................................................................................................ 3
Delta for Calls .................................................................................................................................... 4
Delta for Puts .................................................................................................................................... 4
Delta when options are close to expiration ........................................................................................ 4
Understanding delta better... ............................................................................................................ 5
GAMMA ............................................................................................................................................ 6
THETA ............................................................................................................................................... 7
Note: ......................................................................................................................................... 8
VEGA ................................................................................................................................................. 8
Example..................................................................................................................................... 8
Solution ..................................................................................................................................... 8
Vega with time to expiration ...................................................................................................... 9
RHO................................................................................................................................................... 9
Summary ......................................................................................................................................... 10

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OPTION GREEKS
Option prices can change due to directional price shifts in the underlying asset, changes in
the implied volatility, time decay, and even changes in interest rates. Understanding and
quantifying an option's sensitivity to these various factors is not only helpful -- it can be the
difference between boom and bust.

Greeks are parameters describing and quantifying various risk attributes associated with
options, hence understanding greeks is essential for trading options. Every strategy will have
associated Delta, Gamma, Vega, Theta and others which will help determine the risk and
potential reward for that strategy.

We will look at the most commonly used greeks in this module: Delta, Gamma, Vega, Theta
& Rho.

DELTA
Options are derived contracts on underlying securities, so obviously a change in price of the
underlying security is going to cause a change in the options price. However, the change in
the options price may/may not be exactly same as that of the underlying. Delta is the
option's sensitivity to changes in the underlying stock price. The concept of delta originates
from pricing models used for Options and it measures the expected price change of the
option given a $1 change in the underlying and ranges from -1 to 1.

One of the most widely used option pricing formula, the Black Scholes:

In the above formula, to derive delta, which is the rate of change of options price with
change in stock price, we need

To be more precise N(d1) represents the Delta.

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Delta for Calls
Calls have positive delta, between 0 and 1. This is because an increase in price of the
underlying pushes the option deeper into the money, hence increasing the options price. A
decrease in underlying pushes the option out-of-the-money, hence making it less lucrative
and option prices drop. Since, the option prices go up when the underlyings price goes up
and vice versa (underlying price and option price are directly related); the delta lies
between 0 and 1. Heres an example. If a call has a delta of .50 and the stock goes up $1, in
theory, the price of the call will go up about $.50. If the stock goes down $1, in theory, the
price of the call will go down about $.50.

Delta for Puts

Puts have a negative delta, between 0 and -1. In case of puts, increase in price of
underlying works in the opposite directions; pushes the put out of the money and the
options price goes down. Same way when the underlyings price goes down, the option is
more favourable; in the money and options price goes up. Underlyings price and option
price are inversely related hence the delta lies between 0 and -1. For example, if a put has a
delta of -.50 and the stock goes up $1, in theory, the price of the put will go down $.50. If
the stock goes down $1, in theory, the price of the put will go up $.50.

Delta for Calls and Puts is shown in the diagram below:

Delta when options are close to expiration

As expiration nears, the delta for in-the-money calls will approach 1, reflecting a one-to-one
reaction to price changes in the stock. Delta for out-of the-money calls will approach 0 and
wont react at all to price changes in the stock. Thats because if they are held until

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expiration, calls will either be exercised to become the stock (the underlying itself) or
they will just expire worthless.

Understanding delta better...

To get an intuitive feel of delta, it can be thought of as a measure of the probability that an
option will expire in the money. Usually an At-the-money call option has a delta of 0.5.
Thats because there should be a 50/50 chance the option winds up in- or out-of-the-money
at expiration. To understand this better lets look at the below example:

Example: Consider a call option with strike 50; close to expiration. How will the delta move if
the stock is trading at a) $52 b) $48?

Case a: Since stock price $52 > strike price $50; the option is in-the-money and since its very
close to expiration the probability that it will end in the money is higher. Let us consider a
scenario when this price goes even higher, say to $54; now the probability that the option
will end in the money is even higher; i.e. delta is going up.

Case b: Since stock price $48 < strike price $50; the option is out-of-the-money and since its
very close to expiration the probability that it will end out of the money is higher. Now, if
the stock price drops to $46, the probability of the option ending in-the-money goes even
more down; i.e. delta is going down.

Similarly, you can now think of a scenario for put options.

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GAMMA
The gamma metric is the sensitivity of the delta to changes in price of the underlying asset;
measures the change in the delta for a $1 change in the underlying. Gamma is the rate that
delta will change based on a $1 change in the stock price. So if delta is the speed at which
option prices change, you can think of gamma as the acceleration. Options with the
highest gamma are the most responsive to changes in the price of the underlying stock.

Gamma varies more dramatically as time to expiration comes closer as can be seen in the
graph below:

Below table shows sample data for Delta and Gamma for a stock ABC with strike $50. The
top section shows delta and gamma value for option with sufficient time to expiration and
the section below shows the value when the option is very close to expiration.

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Looking at the above table, we can see how gamma changes for each unit of change in stock
price. Note that gamma (unlike delta) is independent of whether the stock price goes up or
down, it only depends on by how much the delta changes Also note that the price of at-
the-money options will change more significantly than the price of in- or out-of-the-money
options with the same expiration and the price of near-term at-the-money options will
change more significantly than the price of longer-term at-the-money options.

So, higher gamma means your option moves in- or out-of-the-money at an accelerated rate.
If you are an option buyer, then gamma is your friend as long as your forecast is good. This is
because if the option moves in-the-money delta will approach 1 more rapidly but if the
forecast is not good; the delta goes down at the same accelerated rate.

THETA
Theta is the option's sensitivity to time. It is a direct measure of time decay, giving us the
dollar decay per day and is always negative. It is the amount the price of calls and puts will
decrease (at least in theory) for a one-day change in the time to expiration. This is because
the Time-Value of the option melts away at an accelerated rate as the time to expiry
approaches.

At-the-money options will experience more significant dollar losses over time than in- or
out-of-the-money options with the same underlying stock and expiration date. Thats
because at-the-money options have the most time value built into the premium. And the
bigger the chunk of time value built into the price, the more there is to lose. Also note that

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theta for OTM options is lower than that of ATM options because the dollar amount of time-
value for OTM options is lesser.

Note: Owners of options take the position because they believe the underlying stock or
futures will make a move quick enough to put a profit on the option position before the
time value is lost. In other words, Delta beats Theta and the trade can be closed profitably.
When Theta beats Delta, the seller of the option would show gains.

VEGA
To be able to understand this greek, we first need to know the concept of Implied Volatility.

Volatility is simply the amount the stock price fluctuates, without regard for direction. Well
look at two forms of volatility here: Historical Volatility and Implied Volatility.

Historical volatility is simply the annualized standard deviation of past stock price
movements. Implied volatility on the other hand is not based on historical stock price data,
instead it is the future volatility implied by the marketplace based on the price change in
option. Hence, for an option trader implied volatility is more useful than the historical
volatility since its forward looking. Implied volatility can be derived from an options cost.
Option pricing formulae have current stock price, strike price, time to expiration, interest
rate and implied volatility as variables. Implied volatility can easily be calculated by feeding
in the option prices from the market into the option pricing formula (the most commonly
used being Black Sholes).

Vega is the amount call and put prices will change, in theory, for a corresponding one-
point change in implied volatility. Vega does not have any effect on the intrinsic value of
options; it only affects the time value of an options price. As implied volatility increases,
the value of options will increase. Thats because an increase in implied volatility suggests
an increased range of potential movement for the stock. Now, you might be thinking that
the stock can move in either direction, up or down, then why does the value of option
always increase? To understand this let us look at the below example:

Example: A call option on a stock currently trading at $52, has a strike price of $50. If this
volatility increases, explain how will this affect the option?

Solution: If the volatility increases, the stock will either go up or down; let us consider the
below two cases:

a) stock price goes to $56: This pushes the stock further in-the-money; the call holder will
exercise the option and get a positive payoff.

b) stock price goes down to $48: This pushes the option out-of-the-money and the option
expires worthless and is not exercised.

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Vega with time to expiration
The more time remaining to option expiration, the higher the vega. This makes sense
as time value makes up a larger proportion of the premium for longer term options and it is
the time value that is sensitive to changes in volatility. The graph below shows how Vega
varies with time to expiration:

Note: Increased volatility increases the expectation of positive payoff if the option ends in-
the-money, if it pushes the option out-of-the-money, then the option is just expires
worthless and we receive no payoff. There is no case of a negative payoff with increase in
volatility, the option either has positive or 0 payoff and hence the option value goes up with
increase in volatility.

RHO
Rho refers to the interest rate sensitivity of Options. Its the amount an option value will
change in theory based on a one percentage-point change in interest rates. When interest
rates rise, call prices will rise and put prices will fall. Just the reverse occurs when interest
rates fall. Rho is a risk measure that tells strategists by what amount do the call and put
prices change as a result of the rise or fall in interest rates.

More advanced option traders also look at this greek, we will not discuss this in much detail
here. For now you can just keep in mind that if you are trading shorter-term options,
changing interest rates shouldnt affect the value of your options too much. But if you are
trading longer-term options, rho can have a much more significant effect due to greater

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cost to carry.

Summary
The below table gives a summary of how different Greeks affect option valuation:

Let us look at the positive delta. Positive delta tells us that with increase in price of the
underlying, the positions value goes up, so in this case we take the long position on the
option to profit from it. Next, look at the negative vega. This tells us that with increase in
volatility, the positions value goes down, so in this case the short position works in our
favour. Similarly, you can think of all scenarios mentioned in the table above to understand
what positions correspond to the given Greeks.

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