The Greek Letters

1
Options, Futures, and Other
Derivatives, 7th Edition, Copyright
John C. Hull 2008
Options, Futures, and Other
Derivatives, 7
th
Edition, Copyright
John C. Hull 2008 2
Example
A bank has sold for $300,000 a European
call option on 100,000 shares of a non-
dividend paying stock
S
0
= 49, K = 50, r = 5%, s = 20%,
T = 20 weeks, m = 13%
The Black-Scholes value of the option is
$240,000
How does the bank hedge its risk to lock
in a $60,000 profit?
3
Naked & Covered Positions
Naked position(buy &hold)
Take no action. Only one option has been sold.-
unlimited profit or unlimited loss
Covered position(active)
Buy 100,000 shares as soon as option has been
sold. This strategy will work only when option is
exercised.-win win position at the cost of premium

Both strategies leave the bank exposed to significant
risk
Options, Futures, and Other
Derivatives, 7
th
Edition, Copyright
John C. Hull 2008 4
Stop-Loss Strategy
The objective is to hold a naked position when
stock price fall below X and hold covered position
when stock price is greater than X.

This involves:
Buying 100,000 shares as soon as price reaches
$50
Selling 100,000 shares as soon as price falls
below $50
This deceptively simple hedging strategy does
not work well
5
Portfolio of derivatives
Creating portfolio of derivatives need more advance tools
of hedging as risk is more. So we have Delta, Theta,
Row, Gamma, Vega and others.
They are based on based on principal of dynamism,
hedging can be changed with the changing level of risk.
They provide risk coverage from multiple risk factors like
volatility, interest rate, time decay and others.

Greek LetterVariable/Determinant

Delta Change of asset price
Theta Time left for maturity
Gamma Change of change in price
Rho Change in risk free rate
Vega Change in volatility
Options, Futures, and Other
Derivatives, 7
th
Edition, Copyright
John C. Hull 2008 6
Delta (See Figure 17.2, page
361)
Delta (D) is the rate of change of the
option price with respect to the underlying

Option
price
A
B
Slope = D
Stock price
7
Delta
They attempt to make their portfolio unaffected to
small changes in the price of the underlying asset in
the next small interval of time. This is known as delta
hedging.
Suppose a call option whose delta is 0.6. suppose the
option price is 10rs and stock price is 100rs.
Investor has sold 20 option contracts to buy 2000 shares(1
lot=100 shares)
Option position could be hedged by buying 0.6X2000=1200
shares.
The gain / loss of option positions will be offset by gain /loss of
stock positions.
Delta of option -1200 and long shares+1200. so overall delta is
zero.

Options, Futures, and Other
Derivatives, 7
th
Edition, Copyright
John C. Hull 2008 8
Delta Hedging
This involves maintaining a delta neutral portfolio,
when overall portfolio delta become zero. This delta
neutral position is for short period because delta
changes with time. So hedge has to be adjusted
periodically. This is called rebalancing and whole
process is called dynamic hedging schemes
Delta of European Calls and Puts
The delta of a European call on a non-dividend
paying stock is N (d
1
)
The delta of a European put on the stock is


N (d
1
) 1

Options, Futures, and Other
Derivatives, 7
th
Edition, Copyright
John C. Hull 2008 9
Delta Hedging
continued
The hedge position must be frequently
rebalanced
Delta hedging a written option involves a
buy high, sell low trading rule
Examples of delta hedging

10
Theta
Theta is that options Greek which tells you how much an option's
price will diminish over time, which is the rate of time decay of stock
options. Time decay is a well known phenomena in options
trading where the value of options reduces over time even though
the underlying stock remains stagnant.

Time decay occurs because the extrinsic value, which is also known
as the Time Value, of options diminishes as expiration draws nearer.
By expiration, options would have completely no extrinsic value and
all Out Of The Money (OTM) Options would expire worthless. The
rate of this daily decay all the way up to its expiration is estimated by
the Options Theta value.
Options Theta decreases as options go more and more in the money
(ITM) / out of the money (OTM) and is highest when at the money
(ATM). Options Theta also increases as expiration approaches.
11
Theta
Where...
d1 = delta
T = Option life as a percentage of year
C = Value of Call Option
S
t
= Current price of underlying asset
X = Strike Price
R
f
= Risk free rate of return
N(d2) = Probability of option being in the money
12
Gamma
Gamma (G) is the rate of change of delta (D) with respect
to the price of the underlying asset
Gamma is greatest for options that are close to the money
Options delta changes as it starts off at 0.5 when it is At
The Money and then gradually move towards 1 as the
options go deeper In The Money or gradually towards 0 as
the options go farther Out Of The Money. Options Gamma
measures that magnitude as well as the direction of
change.
Positive Options Gamma suggests that the delta of
the option will increase as the underlying stock rises.
Negative Options Gamma suggests that the delta of
the option will decrease towards -1 as the underlying
stock rises.
13
Gamma

Where...
d1 = Delta
S = Current value of underlying asset
T = Option life as a percentage of year

14
Vega
Vega (n) is the rate of change of the value of a
derivatives portfolio with respect to volatility
Options Vega measures the sensitivity of a stock
option's price to a change in implied volatility.
There are 2 main component to a stock option's
price; Intrinsic Value and Extrinsic Value. Implied
volatility of the underlying stock determines the
Extrinsic Value, which is governed by Options Vega.
For Out Of The Money (OTM) Options that contains
nothing more than extrinsic value, their prices are
100% determined by Options Vega! When implied
volatility rises, the price of stock options rises along
with it. Options Vega measures how much that rise is
with every 1 percentage rise in implied volatility.
Options, Futures, and Other
Derivatives, 7
th
Edition, Copyright
John C. Hull 2008 15
Options Vega Characteristics
Positive And Negative Polarity: Long options produces
positive Options Vega while short options produces negative
Options Vega. Positive Options Vega increases the price of
options and negative Options Vega decreases the value of
that position when implied volatility goes up.
Options Vega & Options Moneyness: Options Vega
decreases towards 0 as the option moves deeper In The
Money or farther Out Of The Money. At The Money options
typically has the highest Options Vega value.
Options Vega & Time :Options Vega is higher as time
to expiration becomes longer. The more time to expiration a
stock option has, the more uncertainty there will be as to
where it will end up by expiration, which translates into more
opportunities for the buyer and higher risk for the seller.

Vega
Options, Futures, and Other
Derivatives, 7
th
Edition, Copyright
John C. Hull 2008 16
Vega
Where...
d1 = Delta
S = Current value of underlying asset
T = Option life as a percentage of year
C = Value of Call Option
17
Rho
Rho is the rate of change of the value of a derivative with
respect to the interest rate.
Options Rho have the least impact on stock options pricing.
In fact, this is the options Greek that is most often ignored by
options traders because interest rates rarely change
dramatically and the impact of such changes affect options
price quite insignificantly. Options Rho measures the
estimated change in the theoretical options price with a 1%
change in Interest Rate and is often fairly low. This results in
the price of a call option rising only about $0.01 or $0.02 with
a 1% rise in interest rate, which is very insignificant.
Long call options produces positive Options Rho and long
put options produces negative Options Rho. This means that
call options rise in value and put options drop in value with a
rise in interest rates.

18
Rho
Where...
d1 = Delta
T = Option life as a percentage of year
C = Value of Call Option
X = Strike Price
N(d2) = Probability of option being in the
money