The Greeks: Part 4 in a series of Options brochures brought to you by the JSE.

When trading in options, especially writing options, there are four major risk measures to consider. These risk
factors are often called the Greeks because of the Greek letters used to symbolize these risks in mathematical
formulae. The Greeks consist of but are not limited to: delta, gamma, theta, rho and vega. Option Greeks are the
mathematical characteristics which are used within the Black-Scholes model for pricing options premiums. For
more information about the Black-Scholes model, please refer to Part 2 in the series, titled Options Explained.

Using the Greeks, option traders can calculate the effect of a change in one or more factors that affect the stock
price on the option value. With this mathematical tool, option traders have the ability to hedge their portfolios.
This means they can construct positions using certain risk and reward profiles. Thus a proper understanding of
the option Greeks is essential in learning options trading.

Delta: is the ratio of a change in the price of the underlying to the price of the option. The formula to calculate
delta is: (change in price of option) / (change in price of underlying). Delta is also called the hedge ratio. A future
always has a delta of 1: regardless of the change in price, a certain amount of stock will have to be delivered
upon expiry. This amount is known and static throughout the life of the future. Hence futures are sometimes
called delta 1 products by investment professionals. An options delta is far less certain and changes every day
because the requirement to deliver the stock depends on the relationship between the strike price of the option
and the expiry price of the underlying.

To cover the fluctuating risk of options that have been sold and end in the money or out the money, a continuous
process of buying and selling stock is used by option writers. This is called delta hedging or dynamic hedging.
During the life of the option, the delta ratio will change due to changes in the time till expiry, changes in implied
volatility and changes in the underlying stock price. An at the money call option has a delta of 0.5. An at the
money put option has a delta value of -0.5. This delta value means that there is a 50% chance the option will end
in the money and a 50% chance it will end out the money. As the value of the option increases, the amount of
stock (for a written call) or money (for a written put) needed to hedge the position increases.

The idea behind delta hedging is that when hedging for a call option you have sold, you will have bought the
stock to deliver at a cheaper average price than the strike price of the option. Lets consider an example. You are
an option writer and the price of the underlying is R10 when you sell a R20 strike call option. As the price of the
underlying increases, you buy stock using the delta ratio as your guide. Thus by the time the underlying reaches
R20, you will be largely covered at an average stock price lower than R20, allowing you to profit despite the
option ending in the money.
For an out the money put option, the deliverable will be the money required to purchase the stock in the market,
at a higher price than it is currently trading at. An option writer covers this risk by having sold the stock at a
higher average price than he is required to purchase the stock at upon expiry. Lets consider an example. You
are an option writer and you sell a R10 strike put option when the underlying is at R20. You will short the shares
as the price declines from R20 towards R10, thus obtaining a higher average price for the shares you sold than
the strike price of the option. The idea here is that you are left with a cash surplus despite the option expiring in
the money.
At expiry, a call option will have a delta value of 0 or 1. A delta of 0 means the option is out the money and will
not be exercised. A delta of 1 means that the option has expired in the money and will be exercised and the
option writer will be called upon to deliver the stock so he will need to have the full amount required by the call
option he sold. At expiry a put option will have a delta value of 0 or -1. If the put option expires in the money
(delta value of -1), the option writer will have to buy the stock at the strike price from the purchaser of the option.

Gamma: represents the rate of change in delta. Gamma risk is the risk to option writers of sudden changes in
delta. A sudden change in delta means drastic changes in the amount of stock required to hedge the options
they have sold. The worst case scenario is an option expiring almost exactly at the money. This means that over
the last few hours of the options life, the amount of stock needed to hedge it will switch in a binary fashion from
100% to 0%. The risk is that the option writer will end up with 100 shares he doesnt want and will not be
compensated for or he will need to deliver 100 shares that he does not have and will have to purchase them for
more than he will receive from the purchaser of the option if exercised. Luckily, purchasers of options do not
have to worry about gamma risk. Gamma risk is what makes option writers work hard for their premiums.

Theta: represents the decay of the options value as time passes. As the option nears expiry, there are less days
in which a positive price movement can occur. This means that a one year option is far more costly than a 3
month option, as there is less time in which a price movement can occur. Similarly as each day passes, the
option has one day less of time value. An option has 2 main kinds of value that make up its price:

Intrinsic value which is the strike price- spot price (for a put) and spot price strike price (for a call), and

Time value which makes up the rest of the value of the option. It is a measure of the probability that future
favorable moves can occur. Time value increases as implied volatility increases. Time value decreases as the
period remaining until expiry decreases.
At expiry, all the time value of the option is gone and only intrinsic value remains, as there is no chance for
further positive price movements. Time value decays exponentially with the greatest fall in value occurring over
the last few days of the options life.

Vega: is a monetary risk measure of the impact that a change in the implied volatility will have on an options
value. An options vega risk decreases as the option nears expiry since there is less time for the projected
volatility to influence the final outcome of your option trade. Vega is usually measured as the price change in
Rand of an option for a 1% move in implied volatility. Generally, if you are long an option you are also long
implied volatility. Vega is a measure of downside volatility risk. Thus if you are long an option, then vega is the
Rand amount you will lose if the implied volatility decreases by 1%. If you are short an option, it is the risk that
implied volatility will increase by 1%, meaning you have sold your option too cheaply. Implied volatility is volatility
implied by option premiums trading in the market. It generally has a strong correlation with historical volatility but
can move independently. Thus even if the price of the underlying does not change, a change in volatility can still
occur. Implied and historical volatility tend to increase much faster when prices fall. This is generally because
markets fall rapidly but rise more gradually. Volatility often decreases when a share price increases. This means
that sometimes your call option can decrease in value despite the underlying stock having moved in your favour
above the strike price.

Rho: measures the sensitivity of the option price to changes in the risk-free interest rate. Since SAFEX Options
are based on Futures contracts, rho is zero and will not be discussed in detail in this brochure.

Calculating the Greeks: The JSEs Options webpage has a link to a web-based portfolio options initial margin
calculator that, in addition to calculating option premium and initial margin, also calculates and displays the
values of the Greeks. The initial margin calculator is available in the Calculators section of the following
webpage:

www.safex.co.za/options
Links to sister brochures:

http://www.jse.co.za/Libraries/SAFEX_ED_-_Products_-_Equity_Options_-
_Brochures/A_brief_introduction_to_Options.sflb.ashx

http://www.jse.co.za/Libraries/SAFEX_ED_-_Products_-_Equity_Options_-
_Brochures/JSE_Equity_Options_Explained.sflb.ashx

http://www.jse.co.za/Libraries/SAFEX_ED_-_Products_-_Equity_Options_-
_Brochures/Option_Trading_Strategies.sflb.ashx

Options are fascinating and interesting financial instruments. To further your understanding of options,
we recommend the following books:

John C. Hull, Options, Futures and other derivatives, Sixth Edition

Paul Wilmott, Derivatives: The Theory and Practice of Financial Engineering

Espen Gaared Haug, The complete guide to option pricing formulas, Second Edition

Contact information:

For more information about options:

Johannesburg Stock Exchange Equity Derivatives Trading Division

Tel: +2711 520 7000

E-mail: options@jse.co.za

www.jse.co.za