3.3.8 The Greek Letters

8. The Greek Letters

Greek letters measure different aspects of risk in derivatives.

Delta: Sensitivity of derivatives to changes in the price of the underlying asset.

Gamma: Sensitivity of derivatives’ delta to changes in the price of the underlying asset.

Vega: Sensitivity of derivatives to changes in the implied volatility of the underlying asset.

Theta: Sensitivity of derivatives to the passage of time.

Rho: Sensitivity of derivatives to changes in the interest rates.

8.1 Delta

8.1.1 Introduction of Delta

Delta($\Delta$) can be shown as the slope of the option price curve, relating the option price to the underlying asset price.

According to the BSM model,

• Long European call option $\Delta =N(d_1)$, which range from 0 to 1, and when it is at the money, $\Delta \approx 0.5$
• Long European put option $\Delta =N(d_1)-1$, which range from -1 to 0, and when it is at the money, $\Delta \approx -0.5$
  

When $t\to T$, delta is unstable.

8.1.2 Delta of Financial Instruments

	Without dividend	Continuous Dividend
Call Option	$N(d_1)$	$e^{-qT}N(d_1)$
Put Option	$N(d_1)-1$	$e^{-qT}[N(d_1)-1]$
Stock	1	1
Forward	1	$e^{-qT}$
Futures	$e^{rT}$	$e^{(r-q)T}$
Portfolio	${\sum }_{i=1}^n{w}_i{\Delta }_i$

8.1.3 Delta Hedging

Delta neutral position: the delta of overall position is zero.

The portfolio combines the underlying assets with the options, and the portfolio value does not change with small volatility of the price of underlying assets.

Number of options needed to delta hedge:
$${\Delta }_{\text{Hedged position}}=N_{\text{call/put}}\times {\Delta }_{\text{call/put}}+N_{\text{stock}}\times 1=0$$
$$N_{\text{call/put}}=-\frac{N_{\text{stock}}}{{\Delta }_{\text{call/put}}}$$

Dynamic-hedging: the delta measurement is a linear estimation and the delta-neutral position will no longer hold when the value of the underlying asset experiences large changes. In order to keep hedging, the portfolio has to be adjusted (rebalancing) periodically.

The cost of delta hedging comes from the fact that traders always buy stocks immediately after price risk and sell immediately after price fall. This is a ‘buy high, sell low’ strategy, which is almost certainly costly.

Static-hedging: the hedge is set ip initially and never rebalance it. It is also referred to be “hedge-and-forget”.

8.2 Gamma

8.2.1 Introduction of Gamma

Gamma($\Gamma$): is the rate of change of the option’s delta with respect to the price of the underlying asset, and measures the curvature/stability of the option price.

Gamma is the same for call and put option. Long call/put option, $\Gamma >0$, short call/put option, $\Gamma <0$

Gamma is largest when an option is at-the-money. If the option id deep in or out of the money, gamma approaches to zero.

When time approaches to maturity, gamma gets higher.

8.2.2 Gamma Hedging

The gamma measures the stability of delta. A large gamma indicates that delta will be changing rapidly.

If gamma is higher, rebalancing more frequently is required.

If gamma is relatively small, delta changes slowly and rebalancing is required relatively infrequently.

Thus Gamma is used to correct the hedging error associated with delta-neutral position by providing added prectection against large movements in the underlying asset’s price.

For Neutral Position

• Delta Neutral Positions (the delta of overall position zero): hedge small changes in stock price.
• Delta and Gamma Neutral Positions (the gamma and delta of overall position are both zero): hedge larger changes in stock price.

Gamma of stocks or forward = 0

Create delta and gamma neutral position

• First, creating gamma-neutral position by non-linearly instruments, such as options and bonds. It is likely to change the portfolio’ delta.
  $${\Gamma }_{\text{hedged position}}={\Gamma }_{\text{portfolio}}+N_{\text{call/put}}\times {\Gamma }_{\text{call/put}}=0$$
  $$N_{\text{call/put}}=-\frac{{\Gamma }_{\text{portfolio}}}{{\Gamma }_{\text{call/put}}}$$

• Then, creating delta-neutral potion by linearly instruments, such as stocks and forwards.
  $${\Delta }_{\text{hedged position}}={\Delta }_{\text{portfolio}}+N_{\text{call/put}}\times {\Delta }_{\text{call/put}}+N_{\text{stock/forward}}\times 1=0$$

$$N_{\text{stock/forward}}=-({\Delta }_{\text{portfolio}}+N_{\text{call/put}}\times {\Delta }_{\text{call/put}})$$

8.3 Vega

8.3.1 Introduction of Vega

Vega is the rate of change of the value of the option with respect to the volatility of the underlying asset.

Vega of a call is equal to the Vega of a put.

If Vega is highly positive or highly negative, the portfolio’s value is very sensitive to small changes in volatility.

Vega is greatest for options that are closely at the money. While tends to zero as the option moves deep in and out of money.

Vega of options with longer maturity is relatively larger.

Unfortunately, hedging vega risk is not as easy as hedging delta risk. The vega of a position in the underlying asset is zero. This means that trading the underlying asset does not affect the vega of a portfolio of derivatives dependent on the asset. Vega can only be adjusted by taking a position in another derivative dependent on the same asset

8.3.2 Compare Vega with Gamma

Both Gamma and Vega are positive for a long position in either a call option or put option.

Both Gamma and Vega are largest when the option is at the money, and approach zero as the option moves deep in or out of the money.

Important difference is that while Vega increases as the time to maturity increases, Gamma decreases.

8.4 Theta

Theta($\theta$) is the rate of change of the value of the option with respect to the passage of time (time decay).

As time passed, most options tend to become less valuable, so theta is usually negative for an option.

There is no uncertainty about the passage of time, so it usually will not hedge against the passage of time. Despite this certainty regarding time, traders do like to monitor theta. One reason for this may be that theta and gamma are negatively related for a delta­neutral portfolio. Theta therefore contains information about gamma when delta is maintained at zero. When theta is highly negative, gamma tends to be highly positive; when theta is highly positive, gamma tends to be highly negative.

For long position, $\theta <0$, means option lose value as time goes by. Short-term at the money option has greatest negative theta.

8.5 Rho

Rho($\rho$) is the rate of change of the value of the option with respect to the interest rate.

The impact on option prices when interest rates change is relatively small. The influence of interest rates is generally not a major concern.

Long call $\rho >0$, Long put $\rho <0$

Long-term in-the-money calls and puts are more sensitive to changes in interest rates than short-term out-of-the- money options.

8.6 Summary

	Delta	Gamma	Vega	Theta	Rho
Sensitive Factor	S	$\text{Delta}$	$\sigma$	t	r
Long Call	$+$	$+$	$+$	Usually $-$	$+$
Short Call	$-$	$-$	$-$	Usually $+$	$-$
Long Put	$-$	$+$	$+$	Usually $-$	$-$
Short Put	$+$	$-$	$-$	Usually $+$	$+$
When $t\to T$	More Unstable	Increase	Decrease	Increase $\theta$

8.7. Others

8.7.1 Naked and Covered Position

If you sell a call option without owning the underlying asset, you hold a naked option.

If you sell a call option while owning the underlying asset, you have a covered position.

8.7.2 Stop-loss Strategy

Stop-loss Strategy hedges the short position of a call option by buying an underlying stock when its price rises above strike price $K$ and selling it immediately when its price falls below strike price $K$.

The objective is to hold a naked position whenever the stock price is less than $K$ and a covered position whenever the stock price is greater than $K$.

$S<K$ $\to$ naked strategy, $S>K$ $\to$ covered strategy

Although “superficially attractive”, the strategy becomes too expensive if the stock price crosses the strike price level many times.

8.7.3 Portfolio Insurance

A put option on portfolio can provide protection against the market declines while still keeping the potential for a gain. In addition to buying put positions within the portfolio, manager can construct by synthesizing a put position.

Using underlying assets to create reverse position which has a delta equal to the delta of the required option.

Using index futures to create reverse position which has a delta equal to the delta of the required option.