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Hedging Option Greeks: Risk Management Tool

for Portfolio of Futures and Option

Conference Paper · October 2015

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 Hedging Option Greeks: Risk Management Tool for
Portfolio of Futures & Options.

ABSTRACT

Options are financial derivatives which are used as risk management tools for hedging
the portfolios. The options traders can play safe in the volatile markets with the help of
knowledge of the Greeks associated with the options. This study is focussed at providing the
knowledge of the Greeks and their implementation as risk management tools so as to enhance
gains or avoid losses. Delta, Vega and Theta of the options as well as the other position Greeks
are associated with the any option strategy and they equally impact the portfolio. The
knowledge of impact of Greeks on different strategies will lead to determine how much risk
and potential reward is associated with the portfolio. The study will focus on getting instrument
rated with options trading perspective, in order to make investor handle any strategy scenario
and hedge the risk so as to gain good rewards. This will also guide the investor to determine
the risk reward ratio, prior to entry in the trade. Options trading can be taken to next level with
the help of understanding of Greeks and their Hedging techniques. This knowledge will
enhance the existing knowledge in context to the options hedging and will lead to the benefits
in trading if Delta-Gamma neutralised strategy or Delta-Vega neutralised strategy will be
employed along with the best market movement suited option strategy.

KEYWORDS: Financial derivatives, Hedging, Risk Management, Option Greeks, Options

Trading.

JEL CLASSIFICATION: G23, G20, G0, E44.

INTRODUCTION

In the financial literature, the Greeks are referred to as the quantities representing the
sensitivity of the portfolio of the derivatives with respect to underlying parameters like the spot
prices and their volatilities. As these quantities of sensitivities are denoted by the Greek letters
(Δ, Γ, ν, Θ, ρ), that’s why the name Greeks is given to them. They are also known by the names
as risk sensitivities, hedge parameters or risk measures. Mathematically, the Delta and the
Gamma are the first derivative and second derivative with respect to the underlying spot price.
Other Greeks like Vega, Theta, and Rho are calculated as the first order partial derivatives of
the portfolio value with respect to the underlying parameters or factors which determine the
value of an option. The five Greeks that this study will focus on are Delta (first derivative of
the price of underlying), Gamma (2nd derivative of price), Vega (volatility), Theta (time), Rho
(risk-free interest rate).
In order to reduce the risk associated with portfolio, hedgers use options. The Greeks
can be used as risk management tool for portfolios containing options, futures and stocks. The
change in the portfolio value containing options is subject to the change in the option
sensitivities summarized in delta, gamma, vega, theta and rho. In construction of any strategy,
Delta, Vega and Theta, as well as other Greek positions, play a vital role. To know the reward
and the risk associated with the specific strategy or the portfolio, one can calculate Greeks
value when the options are traded outright and otherwise also. Knowing what the Greeks are
telling is as important as hedging your portfolio risk with any other tool of risk management.
Greeks can be used for establishing a strategy design using linear and quadratic programming
or with the help of different sophisticated software. But for simply hedging the risk associated
with the portfolio, basic knowledge of Greeks and their implementation will be beneficial. One
should try to match his/her outlook on a market with respect to the position Greeks in a strategy
so that if their outlook is correct and then they can capitalize on favorable changes in the
strategy at every level of the Greeks.

LITERATURE REVIEW

This section reviews the literature on determining the use of Greeks as in how they have
been used as the hedging tools in the derivatives market. Comparison of Delta hedging, Delta-
Gamma hedging, and Delta-Vega hedging of written FX options had been done by Hull and
White (1987) and they concluded that the last of these works best. Willard (1987) calculated
sensitivities for derivative securities which are path independent in multifactor models, while
Ross (1998) calculated sensitivities for European options which are multi-asset. Using an
option pricing context, Ferri, Oberhelman, and Goldstein (1982) examined yield sensitivities
for short term securities, while Ogden (1987) examined corporate bond’s yield sensitivities.
Delta hedging has been widely applied by investors who have positions of long or short
options in their portfolio to hedge risks from the changes of the price of option. Due to its broad
application in financial engineering, there is a vast literature on delta hedging. Hull (2003)
provided an introduction of hedging strategies including delta hedging. Jarrow and Turnbull
(1999) provided a detailed explanation of how to replicate portfolios in order to achieve a delta-
neutral position and implementation of dynamic delta hedging.
Pelsser and Vorst (1994) discussed the determination of the mainly used Greeks in the
context of the binomial model (see Cox and Rubinstein 1983). Garman (1992) christened three
more partial derivatives with the names speed, charm, and color. The duration of option
portfolios was defined in Garman (1985), while Gamma duration and volatility immunization
were defined in Garman (1999). Similarly, Haug (1993) discussed the aggregation of option’s
vegas of different maturities. Estrella (1995) derived an algorithm for the determination of
arbitrary price derivatives of the BMS option formula. He then examined Taylor series
expansions in the stock price and found the radius of convergence. Broadie and Glasserman
(1996), Curran (1993), and Glasserman and Zhao (1999) all considered the estimation of
security price derivatives using simulation. Bergman (1983) and Bergman, Grundy, and
Wiener (1996) derived expressions for Delta and Gamma when volatility is a function of stock
price and time. Grundy and Wiener (1996) also derived the theoretical and empirical bounds
on Deltas for this case.
Garman (1995) introduced some additional terminologies as:
1. Speed = third derivative w.r.t. stock price S, ∂3/∂S3
2. Charm = cross partial w.r.t. stock price S and time t, ∂2/∂S∂t
3. Color = cross partial of delta w.r.t. S and t, ∂3/∂S2∂t

Textbooks (e.g. Hull (1999)) described the basic Greeks of claim values V (q, r, t, σ, S)
in the BMS model as:
1. Delta = first derivative w.r.t. stock price S, ∂V/∂S
2. Gamma = second derivative w.r.t. stock price S, ∂2V/∂S2
3. Theta = first derivative w.r.t. time t, ∂V/∂t
 4. Vega/Kappa = first derivative w.r.t. volatility σ, ∂V/∂σ
5. Rho = first derivative w.r.t. risk free rate r, ∂V/∂r
6. Phi/Lambda = first derivative w.r.t. dividend yield q, ∂V/∂q
Many studies had been conducted regarding hedging with Greeks for the portfolios but
still almost all studies had been conducted in the mathematical perspective. There is a gap in
the explanation of the Greeks with the trader’s perspective, how actively they can neutralise
the Greeks in their portfolios without doing lot of core mathematical calculations (linear and
quadratic programming or seeking out the derivatives).

OBJECTIVE

1. To have an understanding of Greeks and their significance.

2. To know the risks and rewards of the Greeks.
3. To make a trader learn how use of Greeks can be helpful while options trading.
4. To show hedging Greeks can be treated as risk management tool.

METHODOLOGY

This paper explains the use of the five most commonly, and most important Greeks,
namely, Delta, Gamma, Vega, Theta, Rho. Objective of this paper is to explain the concepts,
the importance, uses of the Greeks from trader’s perspective to the existing literature. These
option sensitivities can be used as risk management tools. Widely, Black-Scholes model is used
in the trading platforms for calculating the option Greeks, which is undoubtedly useful for the
derivative traders, especially for the ones who seek to hedge their portfolios from the
undesirable movement in the market. Each Greek calculates the sensitivity of the portfolio
value with respect to the small change in a given underlying parameter, which helps us to
rebalance the portfolio accordingly in order to achieve a desired exposure. Greeks which are
used for hedging like Delta, Theta, and Vega are defined as the changes in the option value
with respect to change in Price, Time and Volatility respectively. Black-Scholes model takes
Rho as primary input, but the overall impact on the option value with respect to the changes in
the risk-free interest rate is insignificant most of the times and that is the reason that higher-
order derivatives which involve risk-free interest rate are not common.
Further explanations in the discussion part will focus on getting instrument rated with
options trading perspective, in order to make investor handle any strategy scenario and hedge
the risk so as to gain good rewards. This will also guide the investor to determine the risk
reward ratio, prior to entry in the trade. Focus will remain on hedging options with the help of
Greeks in order to manage risk and gain potential rewards, so more discussed topic will be
price change, changes in volatility and time value decay as they are responsible for the change
in option value.

DISCUSSION

An option is a financial instrument from the class of derivatives. An option is a contract

between two parties that specifies a future transaction on an asset at a particular price (also
known as strike price). Option gives the right to the buyer, either to buy or to sell the specified
underlying asset for a particular price also known as the strike price on or before a particular
date also known as expiration date. There are two types of options namely call options and put
options. Call option is a right to buy an underlying asset but not an obligation. Similarly, Put
option is a right but not an obligation to sell a specified quantity (lot size) of underlying asset
for specified price (strike price). The process of activation of an option and then trading the
underlying asset at the pre agreed upon price is referred to as exercising it. If the option is not
exercised on or before the expiration date, then it becomes worthless or void. Options are again
classified mainly as American options and European options. European options are the options
which can be exercised only on the expiration date or maturity date whereas American options
are the ones that can be exercised at any time i.e. on or before the maturity or expiration date.

The primary drivers for the option price are current asset price, intrinsic value, and time
to expiration or time value, volatility fluctuations. Out of these the price movement of the asset
will have direct impact on the price of the option. As the price of the underlying asset rises, it
is more likely that the call option price will rise and put option price will fall. Similarly, as the
price of the underlying asset goes down, then the reverse will happen to the call and put prices.
To enter in an option contract, one needs to pay an upfront payment called as Option price or
Premium. The premium of the option consists of two parts namely, intrinsic value and time
value. Intrinsic value is that part of option premium which is not lost due to the passage of time.
Precisely if we talk about intrinsic value then intrinsic value is that amount in the premium by
which the strike price of an option is in the money. And apart from the intrinsic value, there is
time value in the premium. The intrinsic value for the options is calculated as Max {0, X-𝑆𝑝}.
Where X is the strike price and 𝑆𝑝 is the spot price of the underlying asset. Options trading at-
the-money or out-the-money have no intrinsic value, whatever value is of the premium for
option is only the time value that will become zero at the time of expiration. The value option
contracts varies because of the number of different variables apart from the value of the
underlying asset and that’s the reason they are complex to value. There are different models of
pricing like Black-Scholes and the Black model, Monte Carlo option model, Binomial options
pricing model and Finite difference methods for option pricing. Other approaches are Heston
model, Health-Jarrow-Morton framework, Variance Gamma model. Mostly used model is
Black-Scholes model for the determination of the option’s price. It is important to know what
factors actually contribute to the option price movement because the price of the option does
not always move with respect to the underlying asset only.

The option sensitivities related to the option value are the “The Greeks”, also known as
the risk management tools. Precisely if we talk about Greeks then to every small change in a
given underlying parameter, there is a change in the option value, that sensitivity of the value
of a portfolio is measured by each Greek. This measurable sensitivity in return helps to
rebalance the portfolio in order to achieve a desired exposure accordingly. The Greeks are
variables which help in explaining the various driving factors responsible for movement in
options prices (known as premiums also), as known by the investors, traders who deal in
options. Many at times it has been seen that few traders and investors assume that the price
change in the underlying stock or the security is the only driving factor for the changes in the
option premiums. But the fact is because of the time value decay factor and sometimes the
volatility changes, the option premiums move down even when the underlying security or stock
remains unchanged. All option Greeks are derived from a well-known options pricing model
also known as Black-Scholes model. There are variations in this model and all the variations
are used for different purposes related to option Greeks. Cox-Ross-Rubinstein model is used
for equity options as they account for the early exercise of the American style options. Greeks
give an insight on how the option’s value will change if a given variable changes, this variable
is such that can drive options price movement. Further the study will explain about the Greeks
which are first order derivatives like Delta, Vega, Theta, Rho as well as the second-order
derivative of the value function also known as Gamma.
 Delta, Δ, measures the rate of change of the option value (theoretical) with respect to
changes in the underlying asset's price. Delta is the first derivative of the option value with
respect to the underlying security's price. Delta is often used as the “hedge ratio”. When
monitoring option risk, Delta is used as the primary indicator. Delta hedging is also considered
as same process of duration hedging in fixed income portfolio. While preparing a risk
management report, the total equity exposure (summing up the products of amounts exposed)
times the Delta’s for equity, equity index, and any options in the portfolio can be considered.
Delta hedging is same as creating a Delta-neutral portfolio. In this, we immunize the position
against loss or profit variability occurring due to small movements in the market and for
immunizing we take an opposite position in the underlying instrument which is equal in size to
the option’s Delta. Option’s Delta ranges from 0 to 1 for calls in value and 0 to -1 for puts. It
reflects the decrease or increase in the option price with respect to a 1 point movement of the
underlying asset price. Deep in-the-money options have Deltas close to 1 while far out-the-
money options have delta values close to 0.

Gamma, Γ, measures the rate of change in the Delta with respect to changes in the
underlying price. The second derivative of the value function with respect to the underlying
price is considered as Gamma. The change in the Delta with respect to a one point movement
of the underlying asset price is expressed as Gamma and it is generally expressed in percentage.
The Gamma is also constantly changing like Delta, even with small movements of the
underlying asset price. When the asset price is near the strike price of the option, then Gamma
is at its peak value and it starts decreasing as the option goes either deep in the money or far
out of the money and ultimately approaches zero for deep in-the-money options as well as for
far out-the-money options. For effective Delta-hedging for a portfolio, Gamma of the portfolio
must be neutralized so as to ensure that the hedge will be effective across a wider range of the
underlying price movements. All the options which are bought have positive gamma because
as the price increases, Gamma also increases, which in turn will cause Delta to approach 1 from
0 (long call option) and 0 to -1 (long put option). Similarly, inverse is true for short options as
for the options which are sold, Gamma is negative.

Theta, Θ, measures the sensitivity of the derivative value to the passage of time, also
known as the "time decay." The option's Theta is a measurement of the option's time decay.
The options value can be analysed into two parts i.e. the intrinsic value and the time value. The
rate at which options lose their time value, as the expiration date comes nearer is measured as
Theta. Theta is generally expressed as a negative number, an option’s Theta reflects the amount
by which the value of an option will decrease every day. The formula for theta is expressed in
value per year. To know how much value an option will lose in a day, the given theta is divided
by the number of days in a year. Theta is always negative for long calls and puts and almost
always positive for short calls and puts. The total theta for a portfolio of options can be
calculated by adding the thetas for each position in the portfolio. As there is no uncertainty to
the passage of time, that’s why it is not useful to hedge its effect and that is the reason Theta is
not generally used for hedging option positions directly. But still it is useful in knowing how
the option value depreciates as the time passes.
Vega, ν, measures the sensitivity of the derivative of the value of the option with respect
to the implied volatility of the underlying asset. The option’s Vega measures the impact on the
option price due to changes in the underlying volatility. Vega is calculated as the amount of
money that the option value will gain or lose per underlying asset as the volatility rises or falls
by 1%. Both call options as well as put options will gain value with rising volatility, that’s why
it is important for an option trader to keep a watch on the Vega especially in volatile markets.
While few of the option strategies gain due to rise in implied volatility (other parameters
keeping fixed) and others lose due to rise in volatility. Whether small or large, a change related
to the levels of implied volatility will definitely have an impact on the unrealized profit or loss
in any option strategy. If the value of the option increases as the volatility increases then that
is called as long volatility whereas in case of short volatility the option position loses its value
when volatility increases. For long volatility, Vega is positive and for short volatility Vega is
negative. Volatility risk is said to be neutralised if the Vega of the portfolio is neither positive
nor negative. And that’s how we can explain Vega hedge also.
Rho, ρ, measures sensitivity to the interest rate and thus it is the derivative of the value
of the option with respect to the risk free interest rate. Rho is the less used among first order
Greeks because the option value is less sensitive to the changes in the risk free interest rate
than to the changes in other parameters. When the interest rates rise, the prices for call option
will rise and for the put option will fall and inversely it is for the fall in the interest rates. The
rho values are positive for call options and negative for put options and if we talk about the
long-dates options, then Rho value will be large whereas in case of short-dates options, it will
be negligible.

In the following figures the major influences on a long and a short call option price as
well on put option price have been shown. These influences have been explained in the
description of the Greeks.

Increase in Decrease in Increase in Decrease in Increase in Decrease in Increase in Decrease in

the the the time to the time to the the the Interest the Interest
Call Options Underlying Underlying Expiration Expiration volatility Volatility Rate Rate
Long + - + - + - + -
Short - + - + - + - +
Figure 1: Major influences on a short and long call option's price

Increase in Decrease in Increase in Decrease in Increase in Decrease in Increase in Decrease in

the the the time to the time to the the the Interest the Interest
Put Options Underlying Underlying Expiration Expiration volatility Volatility Rate Rate
Long - + + - + - - +
Short + - - + - + + -
Figure 2: Major influences on a short and long put option's price

RISKS AND REWARDS OF THE GREEKS

There have been many strategies from which one can make use of the time decay factor
(option’s Theta), but the risks associated with them are not bearable. And there is strategy like
covered-call writing, which can also be restrictive. In these scenarios, when one is looking for
a way to gain from time decay while neutralizing the effect of actions of prices of the portfolio,
the gamma–delta neutral spread will be the best middle way.

We can keep our portfolio safe with respect to the changes in the price by hedging the
net delta and the net gamma of our position. For explaining the delta-gamma neutralisation, we
have taken an example of ratio call write option strategy in which a call option with lower strike
price is bought than that at which call option is sold. Let’s take an example that if we buy a call
with 130 strike price and sell the call at 135 strike price. We will next eliminate the net gamma
of options selected for the strategy. Before delta hedging, gamma neutralisation is required so
as to make sure the rate of change of delta is fixed for both types of options. Instead of going
through lots of equation models in order to find the ratio for gamma hedging, we can easily
figure out the ratio for gamma neutral by doing the following:

1. Find the gamma for both the option.

2. To find the number of call we need to buy, we take the gamma of the option, round it
to three decimal places and multiply it by 100.
3. To find the number of call options we need to sell, we take the gamma of the option,
round it to three decimal places and multiply it by 100.

So now if 130CE has gamma 0.126 and 135CE has gamma 0.095, we should simply buy
95 calls of 130 strike price and sell 126 calls of 135 strike price. The lot size for options is
100 in this case. So buying 95 calls with gamma of 0.126 will give net gamma of 1197
(0.126*9500). And selling 126 calls with gamma of -0.095 will give net gamma of -1197
[(-0.095)*12600]. This will give resultant gamma of zero. Since now gamma is neutralised
next we will make net delta as zero. So next we consider the delta for the calls. If the delta
for 130CE is 0.709 and for 135CE is 0.418, we see that for 95 calls of 130 strike price will
give delta as 6735.5 whereas 126 calls of 135 strike price will give delta as -5266.8
(negative because of selling the call option). This will give resultant delta as 1468.7. Now
to protect our position from adverse move we will hedge this position and make net delta
equal to zero by selling 1469 shares of the underlying asset. This is simply because the
delta for each share is 1. So selling of 1469 shares will give -1469 delta, which together
with existing options will give resultant delta as zero for whole portfolio.

Now we will calculate the profitability for this strategy as the portfolio is now effectively
price neutral. Next for the profitability we will look for the theta of calls. 130CE has theta
equal to -0.18 and 135CE has theta of -0.27. This implies that theta for 95 calls that are
bought is -1710 and for 126 calls that are sold is 3402, which gives resultant theta equal to
1692. We can interpret this as, the portfolio will make 1692 per day. If we here drop the
formalities of margin requirement and net debits and credits, then this portfolio will require
around 3 Lacs of capital and if the existing portfolio will be held for a week (five trading
sessions) then around 8460 INR can be expected which is around 2.82%. Even if we
consider 20% of this return then it will be 0.5% and if this 0.5% will be annualize
considering the return for five days then it will generate around 36.5% return per year.

CONCLUSION

The Greeks played a key role in strategy behaviour, most importantly in determination
of the prospects for success or failure. The important measurement related to the option
position’s risks and potential rewards is provided with the help of Greeks. The clear
understanding of the basics has helped in executing strategies which can hedge the risk with
the help of Delta-Gamma neutralised or Delta-Vega neutralised methods. Simply to know the
total capital risk in a portfolio consisting of options is not enough. In order to make money out
of options trading and protect the capital from related risks, it is essential to determine the
variety of risk-exposure measurements. As conditions kept on changing due to market changes,
in this context Greeks help traders, investors to determine risk reward ratio of their portfolio
because they can determine how specific portfolio will fluctuate with respect to change in
underlying price of the asset, the volatility fluctuations, and due to passage of time. Options
trading can be taken to next level with the help of understanding of Greeks and their Hedging
techniques. This knowledge will enhance the existing knowledge in context to the options
hedging and will lead to the benefits in trading if Delta-Gamma neutralised strategy or Delta-
Vega neutralised strategy will be employed along with the best market movement suited option
strategy.

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