Introduction to Greeks

CONTENTS
1. What are Greeks?
2. Types of Greeks

1. What Are Greeks?

A Greek measures a certain dimension /
aspect of risk involved in an option position
There are various Greeks
Different Greeks measure different aspects
of risk involved in an option position
(different types of risk)
A trader intends to manage all the Greeks
so as to neutralise them (reduce their
impact to zero) / to hold the risks to an
acceptable level

1. What Are Greeks?...

Why / How do these risks arise?
The value of an option changes when
some fundamental factors change
These fundamental factors are:
o Asset Price
o Time to Expiration
o Volatility of the Asset &
o Interest Rate

2. Types of Greeks
Each fundamental factor affecting the
value of an option is represented by a
Greek. Each Greek measures the
influence of a factor on the value of the
option. They are:
A. Delta
B. Theta
C. Gamma
D. Vega
E. Rho

2A. Delta
It is the rate of change of the option
price wrt the price of the underlying
asset
It is the Slope of the curve that
relates option price to the price of
underlying asset
For a European call option on a nondividend paying stock, Delta is +ve
For a European put option Delta is
-ve

2A. Delta
An investor can take either a long or a
short position in the Call / Put options
So delta of an Option has to be
distinguished from delta of a Position
(long / short) in the option
Typically for any Option (Call / Put):
Delta of a Long position has the same
sign as the delta of the option
Delta of a Short position has the opposite
sign to that of the delta of the option

2A. Delta
Delta of Call is +ve. So a long position on
the Call will have +ve delta whereas
short position in the same call will have
ve delta
Delta of Put is ve. So a long position on
the Put will have ve delta whereas short
position in the same Put will have +ve
delta

2A. Delta
By holding appropriate combination of
stock & option the delta of the overall
position can be neutralised
Neutralising the delta means reducing the
delta of the overall position to Zero
This means: the change in value of the
overall position will be equal to Zero
This is called Delta Hedging

2A. Delta: Thumb Rule for

Hedging
Positive Delta implies that the price of option
increases with an increase in asset price & vice versa
Negative Delta implies that the price of option
decreases with an increase in asset price & vice
versa
If an option has Positive Delta then the position in
asset to be taken for hedging should be opposite to
the position in the option
If an option has Negative Delta then the position in
asset to be taken for hedging should be same as the
position in the option

2A. Delta
A call option has a +ve delta. So the
call price increases with an increase in
stock price & decreases with a
decrease in stock price
Hence:
A long position in a call should be
hedged by short position in stock
A short position in a call should be
hedged by a long position in stock

2A. Delta
A put a option has a ve delta. So the
price of put decreases with an increase in
stock price & vice versa
Hence:
A long position in a put should be hedged
by a long position in the underlying stock
A short position in a put should be
hedged by a short position in the
underlying stock

2A. Delta
Eg 1: Consider a European call option
on a stock which has a delta of
0.522. What is the implication of this
value?

2A. Delta
Ans-1:
The delta of 0.522 indicates that when the stock
price increases by Re.1, the call price increases by:
Rs. 0.522
Similarly when the stock price decreases by Re.1 the
call price decreases by: Re. 0.522
So a long position of 1 call option should be hedged
by a short position in 0.522 shares
A short position of 1 call option should be hedged by
a long position in 0.522 shares
The objective is to hold positions in the option &
stock so that the total change in the overall position
is Zero

2A(a): Delta of a Portfolio

Delta of a Portfolio of options is a function
of the delta of the individual options:
n

wi i
i 1

Where i Delta of option ' i'

w i Quantity of option ' i'

This can be used to calculate the position

required in the underlying asset to make
the portfolio delta = Zero
If such a position is taken the portfolio is
said to be delta neutral

2A(a): Delta of a Portfolio

Eg. 2: A financial institution has the following
positions in options on a stock:
1. Long position in 100000 call options with strike
55 & 3 months to expiry; delta of each option:
0.533
2. Short position in 200000 call options with strike
56 & 5 months to expiry; delta of each option:
0.468
3. Short position in 50000 put options with strike
56 & 2 months to expiry; delta of each option:
-0.508
Calculate portfolio delta and Explain.

2A(a): Delta of a Portfolio

Ans-2: Portfolio Delta = 100000 x 0.533 200000
x 0.468 50000 x (-0.508) = -14900
This means when the stock price increases by
Re. 1 the portfolio value will decrease by Rs.
14900
We have to take a position in the stock such that
the overall change in the portfolio value is Zero.
So the portfolio can be made Delta Neutral by
buying 14900 shares (long position in 14900
shares)

2A(b): Transaction Costs

In order to minimise transaction costs
dealers rebalance their positions once a
day to maintain delta neutrality
If no. of options in portfolio is less then
rebalancing will be expensive
Rebalancing means buying / selling the
required no. of shares to neutralise the
portfolio delta
Given the delta of portfolio only one
transaction in the underlying asset in a day
is required to neutralise the portfolio delta

2B: Theta
Theta () of an option is the rate of change of
the value of the option with the passage of
time, other things remaining the same
Also referred to as Time Decay of option
Theta is generally expressed with reference
to days
When expressed with reference to days it
indicates the change in portfolio value when 1
day passes, other things remaining the same.

2C: Gamma
Gamma of an option on an underlying asset is
the rate of change of its delta with reference
to the price of the underlying asset
If absolute value of gamma is small delta
changes slowly with change in the price of the
underlying asset so adjustments to make the
portfolio delta neutral need to be made only
infrequently
If it is large then delta is highly sensitive to
the price of underlying asset so the
rebalancing has to be done very frequently in
order to maintain delta neutrality of portfolio

2C: Gamma: Technical

Aspects
The equation for gamma shows the change
in the portfolio value that will occur if the
price of the underlying asset changes by a
small amount S during a small interval of
time t for a delta neutral portfolio
A position in the underlying asset has Zero
gamma & cannot be used to change the
gamma of portfolio
In order to change the gamma of a portfolio
a position in the option contract itself has
to be taken

2C: Gamma
By taking a position in a traded option on the
underlying asset, gamma of portfolio can be
neutralised BUT including the option position
will also change the delta of the portfolio.
This will further require neutralising the delta
of portfolio by taking a position on the
underlying asset
So making a portfolio gamma neutral
requires that the delta neutrality of the
combined position be maintained at the
same time

2C: Gamma
Eg. 3: A delta-neutral portfolio has a
gamma of:
-3000. The delta & gamma of a traded
call option are 0.62 & 1.5 respectively.
How can we make the portfolio gamma
neutral?

2C: Gamma
Ans. 3: Making the portfolio gamma neutral means
combining the portfolio with a certain no. of the
options so that the gamma of the combined
position becomes zero.
Gamma of combined position = Gamma of portfolio
+ No. of call options x Gamma of each call option
= -3000 + N x 1.5 (N is no. of call options)
Gamma of combined position should be = 0. Thus
-3000 + N x 1.5 = 0 or N = 3000/1.5 = 2000
This means the portfolio can be made gamma
neutral by taking long position in 2000 call options

2C: Gamma: Ans. 3 Contd

But taking a long position in 2000 call options
will disturb the delta of the combined position.
So a position in the underlying asset has to be
taken to neutralise the delta.
Delta of the combined position after taking
long position in 2000 call options = Delta of
Original Portfolio + Delta of 2000 call options
purchased =
0 + 2000 x 0.62 = 1240
This means 1240 units of the underlying asset
must be sold / shorted to make the combined
position delta neutral

2D: Vega (v )
Vega represents the change in the value
of an option due to changes in the
volatility of the underlying asset
It is the rate of change of the value of the
option with respect to the volatility of the
underlying asset
If the absolute value of Vega is high the
portfolios value is very sensitive to small
changes in volatility
A position in the underlying asset has Zero
Vega

2D: Vega (v )
Vega of a portfolio of options can be
changed by adding a position in a traded
option
A portfolio that is Gamma neutral will
NOT be Vega neutral & vice versa
Being Vega neutral means that the Vega
is zero

2E: Rho
Rho of an option is the rate of change of
the value of the option with reference to
interest rate
It measures the sensitivity of the value of
the option to a change in interest rate,
other things remaining same

2E: Rho
Eg. 4: The rho of a call option on a nondividend paying stock is 8.91.
Interpret this.

2E: Rho
Ans. 4: This means:
An increase in interest rate causes an
increase in the value of the option
(because rho is +ve)
1% increase in interest rate means an
increase in interest rate by 0.01
Rho = 8.91 implies that an increase of
0.01 in the interest rate will cause an
increase of: 0.01 x 8.91 = 0.0891 in the
value of the call option