Option Risk Management

Copyright 2000-2006 Investment Analytics

Agenda
Option sensitivity factors Delta
Delta hedging

Option time value Gamma and leverage Volatility sensitivity Gamma and Vega hedging
Copyright 2000-2006 Investment Analytics Option Risk Management Slide: 2

Option Sensitivity Factor

What affects the price of an option
the the the the the asset price, S volatility, interest rate, r time to maturity, t strike price, X

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 3

Option Greeks
Delta (price sensitivity)
change in option price due to change in stock price

Gamma (leverage)
change in delta due to change in stock price

Vega (volatility sensitivity)

change in option price due to change in volatility

Theta (time decay)

change in option value due to change in time to maturity
Copyright 2000-2006 Investment Analytics Option Risk Management Slide: 4

Option Delta
Key sensitivity
Change in option value for $1 change in underlying stock Range 1 to +1

Option Delta
Put options: negative delta Call options: positive delta

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 5

Delta Example
Call option with Delta 0.5 Delta tells us how the call price changes
If stock moves up by $10, call price increases by $5 If stock drops by $10, call price decreases by $5

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 6

Delta Position
Delta Position
The call behaves like 0.5 units of stock If we hold 10 calls, our position behaves like 5 units of stock we say we are long 5 deltas

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 7

Position Deltas
Call options
have positive delta like being long stock

Put options
have negative delta like being short stock

Stock - has a delta of 1! Bonds - have a delta of zero Combinations

may have positive, negative or zero delta
Copyright 2000-2006 Investment Analytics Option Risk Management Slide: 8

Delta Hedging
If you know the positions delta, you can hedge it Example, 10 calls, each of delta 0.5 How to hedge: Sell Delta units of stock
This creates a portfolio of 10 calls plus -5 units of stock The combined position has a delta of +5 - 5 = 0 Like being long 5 stock & short 5 stock = net zero stock The value of the portfolio will be unchanged, no matter whether the stock moves up or down

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 9

Delta Neutral Positions

A portfolio is hedged when its position delta is zero We say we have a delta-neutral position Examples: assume call delta 0.5, put delta -0.5
Long 10 calls, short 5 stock Long 10 calls, long 10 puts Short 10 calls, long 5 stock Short 10 puts, short 5 stock Short 10 puts, short 8 calls, short 1 stock

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 10

Delta Neutral Strategies

Delta neutral strategies are non-directional
Often make money while market doesnt move

Examples:
Butterflies, straddles, strangles are typically delta neutral

Directional strategies are typically not deltaneutral

Call spreads have +ve delta Put spreads have -ve delta

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 11

The Delta of a Call Option

Delta changes as stock price changes
Gamma measures rate of change of delta
In the money Call Value Out of the money At the money 1

0.5 X Stock Price

Slide: 12

Copyright 2000-2006 Investment Analytics

Option Risk Management

IBM Option Delta

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 13

A New Look at Delta

Probability Delta = Probability of Option Finishing inthe-money

S X.e-rt Out-of-the-Money
Copyright 2000-2006 Investment Analytics Option Risk Management Slide: 14

Delta: At-the-Money
Probability

S = X.e-rt At-the-Money
Copyright 2000-2006 Investment Analytics Option Risk Management Slide: 15

Delta: In-The-Money
Probability Delta 1

X.e-rt
Copyright 2000-2006 Investment Analytics

S
Option Risk Management Slide: 16

In-the-Money

Delta: Conclusions
Delta measures probability of finishing in the money A deep out-of-the money option has a low delta An at-the-money has a delta of around 0.5 as it approaches expiry
i.e. a 50-50 chance of ending up in the money

As an option moves deep into the money, its delta rapidly approaches 1
Gamma measures rate of change of Delta

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 17

Option Value
Intrinsic Value
Asset Price Strike Price Interest rates

Time Value

Time to Expiration Volatility

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 18

How Time Value Decays

9 months 6months 3 months

Premium

Expiration

Stock price

Strike Price
Copyright 2000-2006 Investment Analytics Option Risk Management Slide: 19

Time Decay (Theta)

Decay Acceleration

Premium

0
Copyright 2000-2006 Investment Analytics Option Risk Management Slide: 20

Time Value of IBM Option

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 21

IBM Option Theta

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 22

Option Gamma
Measures change of Delta for $1 change in stock Rate of Acceleration of option value with stock price Call and put options have positive gamma
Option delta becomes larger as stock appreciates Becomes smaller (more negative) as stock declines

Gamma changes as underlying stock moves

Highest for ATM options
Copyright 2000-2006 Investment Analytics Option Risk Management Slide: 23

IBM Option Gamma

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 24

Lab: Leverage
An Experiment:
Assume stock $100 Risk free rate 10%, volatility 25% Call option, strike price 100 (at the money)

Leverage:
If stock moves by $5, how much does option value change?

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 25

Solution: Leverage
Maturity 1.00 0.50 0.25 0.10 0.01 Call S=100 12.34 8.26 5.60 3.40 1.02 Prices S=105 15.66 11.48 8.80 6.69 5.07 Return (%) 27% 39% 57% 97% 396% Gamma 0.015 0.022 0.032 0.050 0.160

NOTES: Col 2 is option value with stock price = 100 Col 3 is option value with stock price = 105 Col 4 is Leverage: (C1 - C2)/C1
Copyright 2000-2006 Investment Analytics Option Risk Management Slide: 26

Time vs Leverage

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 27

Conclusions: Time Value & Leverage

Gamma is a measure of leverage An option with higher gamma gives more bang for the buck Gamma measures how option value accelerates Gamma /Leverage increase as time to expiry falls Gamma and Theta are opposites:
High leverage means rapid time decay

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 28

Volatility Greeks
Vega - sensitivity to implied volatility Gamma - sensitivity to actual volatility Example: Weather
People carrying umbrellas (implied risk of rain) = Vega Rain (the wet stuff) = Gamma

Implied volatility
estimated s.d. implied by option prices by B-S model markets estimate of current volatility

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 29

Vega
Measures change in option value for 1% change in implied volatility Call and put options have positive Vega
Increase in value as implied volatility increases Option positions may have positive or negative Vega

Vega changes with underlying stock

Highest for ATM options
Most sensitive to changes in implied volatility
Copyright 2000-2006 Investment Analytics Option Risk Management Slide: 30

IBM Option Vega

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 31

Lab: Option Sensitivities

Examine Delta, Gamma, Vega & Theta
Characteristic functions

How do they vary over time? How do they vary with volatility?

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 32

Solution: Option Sensitivities

Delta Gamma

Vega

Theta

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 33

Solution: Option Sensitivities

Delta
Short-dated, ATM options on less volatile stock are more sensitive

Gamma
Greatest for short-dated ATM options on less volatile stock

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 34

Solution: Option Sensitivities

Vega
Long-dated, ATM options on less volatile stock more volatility sensitive

Theta
Short-dated ATM options on more volatile stock experience greatest rate of decay

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 35

Volatility Types
Historical Implied Forecast Seasonal

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 36

Historical Volatility
Fama & French study (1965) of US stock prices, tested:
A: Volatility between consecutive trading days B: Volatility over weekend (close Friday to close Monday) Expected B = 3 x A Found B was only 20% higher

Volatility is much higher on trading days Use daily data from trading days (252 per year)
Copyright 2000-2006 Investment Analytics Option Risk Management Slide: 37

Estimating Historical Volatility

Standard Deviation
X i = Ln( Pi +1 / Pi )

( X i X ) 2 / ( N 1)

Parkinson (5x times more efficient)

1 = Ln(Hi / Li ) 2N Ln(2)
Copyright 2000-2006 Investment Analytics Option Risk Management Slide: 38

Gamma Hedging
Suppose unhedged position = one call
You can make it delta neutral But this only works for small changes Need to eliminate gamma risk too

How do you make it Delta & Gamma neutral?

Cant use stock: gamma is zero Must use other options, O1 and O2

Solve:

m1 + n2 = 0 m1 + n2 = 0
Option Risk Management Slide: 39

Copyright 2000-2006 Investment Analytics

Vega Hedging
Make a portfolio Delta-Vega neutral Again, use other options Solve: m1 + n2 = 0 mV1 + nV2 = 0

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 40

Lab: Greek Hedging

Excel: Workbook
Worksheet: Greek hedging

Sensitivity:
Check how position value, delta changes with stock price Check how position value changes with volatility

Hedging:
Gamma hedge the given portfolio Check sensitivity of position to stock price

Use Solver
Copyright 2000-2006 Investment Analytics Option Risk Management Slide: 41

Greek Hedging Using SOLVER

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 42

Solution: Greek Hedging

Portfolio Hedge Net Position Target Abs. Position Quantity 0.0 0.0 99.5 2.0 0.1 0.0 -0.1 -0.7 75.3 0.0 Value -493.9 493.9 -0.0 0.0 0.0 Type C C C C C P P P P P Position Delta Gamma 9.2 -15.9 -9.2 15.9 -0.1 -0.0 0.0 0.0 0.1 0.0 Strike 35 40 45 50 55 35 40 45 50 55 Maturity 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 Vega -1,169.8 1,168.1 -1.7 1,169.8 1.7 Price 10.44 5.53 1.55 0.14 0.00 0.00 0.04 0.99 4.52 9.32 Theta 282.2 -281.6 0.6 282.2 0.6 Delta 1.00 0.97 0.59 0.10 0.00 0.00 -0.03 -0.42 -0.90 -1.00 Gamma 0.000 0.020 0.119 0.053 0.004 0.000 0.020 0.119 0.053 0.004 Stock Volatility Risk Free 45 14.0% 5.0%

Vega 0.01 1.49 8.77 3.90 0.27 0.01 1.49 8.77 3.90 0.27

Theta -1.73 -2.33 -3.70 -1.31 -0.08 0.00 -0.35 -1.47 1.16 2.63

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 43

Summary: Option Risk Management

Option Greeks
Measures of option sensitivity Delta hedging Gamma & Vega hedging

Copyright 2000-2006 Investment Analytics

Option Risk Management

Slide: 44