Options and Greeks

Thota Nagaraju
Dept of Econ & Fin
BITS-Pilani Hyd Campus
Options & Greeks

Thota Nagaraju BITS-Pilani Hyderabad Campus Options & Greeks First Sem 2024-25 1
Derivatives and the Importance of Derivatives Markets
➢A derivative is a financial agreement that gets its value from another asset, such as a stock,
commodity, or currency.
✓Risk Management
✓Price Discovery
✓Liquidity
✓Investment Opportunities
✓Capital Efficiency
✓Financial Innovation
✓Macroeconomic Stability

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Derivatives: Leverage vs Hedging
➢Using Derivatives to Increase Risk through Leverage
Leverage involves using funds you don’t actually own to generate returns, which are more extreme than
those provided by the markets of the underlying securities (the stocks or bonds). When markets are
moving in the investor’s favour, leverage enhances those returns; but when markets turn the other way,
the downside is significantly worse that it would be without leverage.

➢Using Derivatives to Decrease Risk by Hedging

For example, if a farmer wanted to hedge against their crop of wheat losing its value, they could take out an
option to sell their product at the current market price. This would ensure that regardless of market
movements, they have the choice to sell it at the expiry date – but not the obligation.

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Leverage using an example involving options contracts
➢.

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Introduction to Options
➢.

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Option Payoffs
➢.

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Option Moneyness
➢. Stock Price Call Options Put Options

Stock Price > Strike Price In the Money Out of Money

Stock Price = Strike Price At the Money At the Money

Stock Price < Strike Price Out of Money In the Money

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Factors Affecting Option Prices

Variable c p C P
S0 + − + −
K − + − +
T ? ? + +
s + + + +
r + − + −
D − + − +

+ indicates that an increase in the variable causes the option price to increase;
- indicates that an increase in the variable causes the option price to decrease;
? indicates that the relationship is uncertain.
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Put-Call Parity: No Dividends
➢Consider the following 2 portfolios:
❖Portfolio A: European call on a stock + zero-coupon bond that pays K at time T
❖Portfolio C: European put on the stock + the stock
Values of Portfolios

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Put-Call Parity
➢.

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Synthetic Options
➢Synthetic options are portfolios or trading positions holding a number of securities that when
taken together, emulate another position.
➢The payoff of the emulated, synthetic position and the actual position should, in theory, be
identical.
➢If the prices for these two are not identical then an arbitrage opportunity would exist in the
market.
➢Assessing synthetic options can be used to determine what the price of a security should be. In
practice, traders often create synthetic positions to adjust existing positions.

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Synthetic Long Stock
➢.

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Synthetic Short Stock
➢.

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Synthetic Long Call
➢.

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Synthetic Short Call
➢.

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Synthetic Long Put
➢.

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Synthetic Short Put
➢.

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Option Value
➢ Option value can be
decomposed into two parts:
1) Intrinsic value:
payoff if option would be exercised today
2) Time/extrinsic value: the value of the
option above its intrinsic value,
taking into account the chance
that the option may be worth
more at expiry

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 Directional Option Strategies
➢.

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Vanilla Calls / Puts : Simplest Ways for Directional Exposure
➢.

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Call / Put Spreads : Limited Directional Exposure
➢.

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Call Overwriting :Yield Enhancement
➢.

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Put Underwriting: Yield Enhancement
➢.

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Ratio Spreads : Cheap Structures For Limited Market Moves
➢.

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 Volatility Based Option Strategies
➢.

Volatility Based Option Strategies

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Volatility Skew
➢.
In the options universe, the term "volatility skew" refers to the uneven distribution of
implied volatility across different strike prices and expiration dates of options contracts.
Implied volatility reflects the market's expectation of future price movements for the
underlying asset. The volatility skew therefore illustrates how this expectation varies
depending on the option's strike price and time to expiration.

Typically, at-the-money (ATM) options tend to have higher implied volatility compared to
out-of-the-money (OTM) options. That means options with strike prices that are close in
value to the underlying stock/ETF price will have higher implied volatility, while upside
calls often have lower implied volatility. Downside OTM puts may also exhibit higher
levels of implied volatility due to firm demand for these options.

Downside puts are often used for hedging, which can help mitigate losses in the event of
a sharp market correction. The presence of a volatility skew is therefore primarily
attributable to market participants' expectations and perceptions of risk. In general, skew
tends to be structured such that higher risk options exhibit higher levels of implied
volatility, while lower risk options exhibit lower levels of implied volatility, all else being
equal.

For example, during times of heightened uncertainty or market turbulence, investors The Interpretation of a Volatility Skew
may demand greater downside protection, leading to elevated implied volatility for out- Interpreting a volatility skew involves understanding the implications of the shape and slope of the skew. Some interpretations of
of-the-money puts. Similarly, in bullish markets, there may be less demand for downside the volatility skew include:
Positive or Forward Skew: If the skew is positive, it means that OTM call options have a higher implied volatility than OTM put
protection, resulting in relatively lower implied volatility for out-of-the-money puts
options. This is often seen in commodities markets where a sudden demand spike can lead to significant price increases. A positive
compared to at-the-money or in-the-money options. skew suggests that the market is expecting an upward price movement.
Negative or Reverse Skew: If the skew is negative, it means that OTM put options have a higher implied volatility than OTM call
Traders and investors closely monitor volatility skew as it can provide important insights options. This is often seen in equity markets where investors are more concerned about price drops and hence are willing to pay
into market sentiment. A skew analysis can likewise help an options market participant more for put options to protect their investments. A negative skew suggests that the market is expecting a downward price
assess the relative pricing of options across different strike prices and expiration dates, movement.
guiding their potential trading strategies. Smile: If the implied volatility is higher for both OTM call and put options compared to ATM options, it creates a "smile" shape. This
is often seen in markets with high uncertainty or expected large price movements in either direction.
Flat or Neutral or No Skew: If there is no skew, it means that the IV is the same for all options, regardless of the strike price. This
suggests that the market does not expect significant movements in either direction.

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Term Structure
➢.

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Call / Put Spreads : Skew Play
➢.

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Risk Reversal : Hedging the Reversal of Risk
➢.

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Strangle / Straddle : Trading Expectation of Future Moves
➢.

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Butterfly : Making Returns in a Neutral Environment
➢.

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Calendar Spreads : Term Structure Play
➢.

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Binomial Option Price (Discrete Option Pricing Model)
A derivative lasts for time T and is dependent on a stock

Value of a portfolio that is long D shares and short 1 derivative:

The portfolio is riskless when S0uD – ƒu = S0dD – ƒd or

ƒu − fd
D=
S 0u − S 0 d
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Generalization (continued)

➢Value of the portfolio at time T is S0uD – ƒu

➢Value of the portfolio today is (S0uD – ƒu)e–rT
➢Another expression for the portfolio value today is S0D – f
➢Hence ƒ = S0D – (S0 uD – ƒu )e–rT
➢Substituting for D we obtain
ƒ = [ pƒu + (1 – p)ƒd ]e–rT

Where

e −d rT
p=
u−d

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Black-Scholes-Merton (Continuous) Option Pricing Model
➢Assumptions
1. The stock price follows a geometric Brownian motion with constant µ and σ
2. Investors can short sell securities with full use of the proceeds
3. There are no transaction costs or taxes. All securities are perfectly divisible
4. There are no riskless arbitrage opportunities
5. Investors can trade securities continuously
6. he risk-free rate r is constant through time and the same for all maturities.

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Derivation of the Black-Scholes-Merton differential equation
➢.

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Derivation of the Black-Scholes-Merton differential equation
➢.

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Derivation of the Black-Scholes-Merton differential equation
➢.

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Derivation of the Black-Scholes-Merton differential equation
➢.

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The concept of Volatility
➢.
Both realized volatility and implied volatility give us information about the asset, and although they are related, they are different concepts.
Realized Volatility:
Also known as historical or statistical volatility, realized volatility is a measure of how much the price of an asset changed during a period of time. Often, volatility is
taken to be the standard deviation of the movements in the price. If the price of a stock at various times is represented as S(ti), realized volatility can be calculated as:

252 N  S (ti ) 
2

s=  ln  
N i =1  S (ti − 1) 
The term of 252/N is the annualization factor (for 252 business days in the year).

Implied Volatility: SX5E 3m ATM Implied Vol

The realized volatility of an asset is called its historical volatility because it reflects the past; SX5E 3m Realized Vol
however, it does not necessarily contain information about the current market sentiment. 50%

40%
The implied volatility of an asset, on the other hand, is a representation of what the market is
implying in terms of volatility. Using the Black-Scholes formula, any given price corresponds to 30%
one and only one volatility parameter. In fact, vanilla options are quoted in terms of their implied
volatilities, as this essentially amounts to the same information. 20%

10%
In general, implied volatility is higher than the realized volatility. Jan11 Apr11 Jul11 Oct11 Jan12

40
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Implied Volatility calculation using Excel
➢.

41
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Implied Volatility calculation using Excel
➢.

42
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What causes Volatility?
➢.

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Market Maker Risk Management

Market Maker Risk Management

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Market Maker Risk Management
➢Market makers play a crucial role in ensuring liquidity and efficiency in financial markets by
facilitating the buying and selling of securities.
➢However, they face various risks in their operations, and effective risk management is
essential to maintain their profitability and stability.
➢Here are some key aspects of market maker risk management:
✓Market Risk (Price, Interest rate, Commodity etc)
✓Credit Risk
✓Exchange Rate Risk
✓Liquidity Risk
✓Operational Risk
✓Model Risk
➢To manage the aforementioned risks (not limited to those mentioned above), the market
maker utilizes derivative products in conjunction with other financial securities. In this
course, we focus solely on derivative products due to time constraints.

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What is Risk and Uncertainty
➢ In the ordinary sense, the risk is the outcome of an action taken or not taken, in a particular situation which may result in loss
or gain. It is termed as a chance or loss or exposure to danger, arising out of internal or external factors, that can be minimized
through preventive measures.
➢ By the term uncertainty, we mean the absence of certainty or something which is not known. It refers to a situation where
there are multiple alternatives resulting in a specific outcome, but the probability of the outcome is not certain. This is
because of insufficient information or knowledge about the present condition. Hence, it is hard to define or predict the future
outcome or events.
➢ The difference between risk and uncertainty can be drawn clearly on the following grounds:
i. The risk is defined as the situation of winning or losing something worthy. Uncertainty is a condition where there is no knowledge about the future
events.
ii. Risk can be measured and quantified, through theoretical models. Conversely, it is not possible to measure uncertainty in quantitative terms, as the
future events are unpredictable.
iii. The potential outcomes are known in risk, whereas in the case of uncertainty, the outcomes are unknown.
iv. Risk can be controlled if proper measures are taken to control it. On the other hand, uncertainty is beyond the control of the person or enterprise, as
the future is uncertain.
v. Minimization of risk can be done, by taking necessary precautions. As opposed to the uncertainty that cannot be minimized.
vi. In risk, probabilities are assigned to a set of circumstances which is not possible in case of uncertainty.
According to American economist Frank Knight, risk is something that can be measured and quantified, and that the taker can take steps to protect himself
from. Uncertainty, on the other hand, does not allow taking such steps since no one can exactly foretell future events.
A risk may be taken or not, while uncertainty is a circumstance that must be faced by business owners and people in the financial world.
Taking a risk may result in either a gain or a loss because the probable outcomes are known, while uncertainty comes with unknown probabilities.

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Nature of Firm-wide Risks
➢.

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Is it best to avoid risk?
➢.

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Why Risk Management is Important?
➢.

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Plain Vanilla Types Options

➢Plain Vanilla -→ Our entire DRM course dealt with the “plain vanilla” options only.
Meaning that Plain vanilla options are the most basic version of a financial instrument
and comes with no special features

European American

Call Put Call Put

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Exotic Type options (Only basic introduction, no pricing and no trading strategies)
➢An exotic option is an option whose payoffs or exercise features are different from those of
standard (“plain vanilla”) calls and puts. An immense variety of exotic options trades in the
over-the-counter market.
➢“Different” does not always mean more complex. Some exotics, such as lookbacks and
Asians, do involve more complex payoffs than plain vanilla options, but others, such as
binary options, have very simple payoff structures. Nor should the word “exotic” be taken
to imply that these options are rare; to the contrary, some exotics, like barrier options,
have become commonplace in the market.
➢Exotic options provide richer and more targeted payoff patterns than can be obtained from
vanilla options. For example, an Asian option addresses a specific kind of hedging need—
exposure to the average—more efficiently than vanilla options.

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Exotic Type options
➢There are two broad categories of exotic options. The first is path-independent exotics. These are
exotic options whose payoff at the time of exercise may depend on the price of the underlying at
that point, but not on how that price was reached, i.e., not on the past behavior of prices.
➢In a path-dependent exotic, the payoffs from the option at the time of exercise may depend not
only on the price of the underlying at that time but also on some or all of the entire path of prices
leading to that terminal price.
Exotic Options

Path Independent Path Dependent

Binary Barrier
Choosers Asian
Compound Lookback
Quanto Shout

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Binary options (Path-Independent)
➢The term binary (or digital) option is used to refer to any option with a discontinuous
payoff structure. While several examples of such options exist, by far the most prominent,
and the canonical example of binary options, is the cash-or-nothing option. A cash-or-
nothing option is simply a straight bet on the market: the option holder receives a fixed
amount of cash (say, M) if the stock price finishes above the strike price K at maturity T of
the option, and nothing otherwise.
➢A variant on this theme is the asset-or-nothing option in which the holder of the option
receives one unit of the asset if the option finishes in-the-money ( S ≥ K ) and nothing
otherwise.

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Chooser Options (Path-Independent)
➢ Chooser option (also called an “as-you-like-it” option or a “U-Choose” option) is an option
in which the holder has the right to decide by a specified time whether the option is to be a
put or a call. The strike and maturity of the call and put are specified in the contract. The
choice date, of course, occurs before the maturity dates. In the typical case (called a
“standard chooser”), the call and put have the same strike and maturity. In a “complex
chooser,” the put and call may have different strikes and maturities.

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Compound Options (Path-Independent)
➢ A compound option is simply an option written on an option, i.e., one in which the underlying asset is itself an option written
on another asset. The strike price in a compound option is the price at which the holder of the option may purchase or sell the
underlying option. To distinguish between the two options’ strike prices, the strike price of the compound option is sometimes
referred to as the “front fee” while that on the underlying option is the “back fee.”
➢ Since the compound can be a call or a put and the underlying option can be a call or a put, there are four basic kinds of
compound options: (i) a call option on a call option, (ii) a call option on a put option, (iii) a put option on a call option, and (iv)
a put option on a put option.

➢ Loosely speaking, compound options enable the holder to lock in a price for insurance while postponing the decision on
whether to obtain that insurance. Suppose, for example, that an investor is debating whether to buy a put option to obtain
protection against a decrease in the price of XYZ stock. Suppose the investor finds current option prices high. If the investor
does not buy the put and the price of XYZ stock does in fact decline, then the price of the put option will go up even further.
That is, the very circumstances in which insurance becomes more valuable to the investor are the ones in which insurance
becomes even more expensive.

➢ To guard against this eventuality, the investor can buy a compound option, in this case, a call on the put. By doing so, the
investor locks in the price at which the put option may be purchased if asset prices do decline and the put becomes more
expensive. Of course, there is no free lunch here; in particular, if asset prices do not decline sufficiently to make exercising the
compound option attractive, the amount paid as premium is lost.

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Quanto options (Path-Independent)
➢Quanto options are cross-currency options in which the option is written on a security that trades in
one currency but the payoff is translated into a different currency in a prespecified manner.
➢To motivate these options, consider an example.
➢Suppose a US-based investor wishes to buy a call option on a French company whose shares trade in
Paris in euros. Then, since the option trades in euros, the investor must bear currency risk at the end of
the transaction: if the call finishes in-the-money, the profit from the call is realized in euros and must be
converted back to US dollars at the then-prevailing exchange rate. If the investor does not want to bear
this exchange-rate risk, she can buy an option in which the euros are converted back into US dollars at a
fixed, prespecified exchange rate. Such an option is a quanto.
➢The NYSE Arca Japan Index Option traded on the erstwhile American Stock Exchange (now part of NYSE
Euronext) is an example of a quanto. The index underlying the contract is constructed using 210 stocks
traded on the Tokyo Stock Exchange. The index value is computed using the yen prices of the respective
stocks. At maturity, the holder of this option receives $100 times the depth-in-the-money of the option.
For example, if the strike price is 110 and the index closes at 114 on the last trading day, the holder of a
call receives $(100 × 4) = $400.

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Path-Dependent Exotic Options
➢Building on the foundations laid in the previous slides in terms of the path-independent
exotic options, here we look at the class of path-dependent exotic options. These are
options whose payoffs upon exercise depend not only on the price of the underlying at that
point but also on some or all of the entire path of prices leading to that terminal price.

➢In general, path dependence makes both the pricing and hedging of exotics more complex.
Pricing becomes computationally more involved because we have to treat each path of
prices separately even if they lead to the same end price. Hedging is complicated by the
fact that the delta measures only the sensitivity of option value to changes in the current
price of the stock (since we can only hedge with stock purchased at the current price),
whereas the option payoffs may depend on past prices as well.

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Barrier Options
➢Barrier options are among the most important of all classes of exotic options. In a nutshell,
they are options that either cease to exist (“knock-out” options) or come to life (“knock-in”
options) when the asset price breaches a prespecified barrier level during the life of the
option.
➢For example, a knock-out put option with barrier H is a put option that gets knocked out
(i.e., ceases to exist) if the stock price crosses the level H during the option’s life. If the
barrier is not breached at any point during the option’s life, the option payoff is the same
as that from a vanilla put. Thus, given a strike K and maturity T , its payoff at maturity is

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Barrier Options
➢As a general matter of classification, we distinguish between barrier options on whether
they are knock-out or knock-in (“out-versus-in” options), and whether the barrier lies
above or below the initial stock price (“up-versus-down” options). Thus, there are four
basic kinds of barrier options:
❖up-and-out options, where the barrier lies above the stock price and the option gets knocked out if the
barrier is breached.
❖up-and-in options, where the barrier lies above the stock price and the option gets knocked in only if the
barrier is breached.
❖down-and-out options, where the barrier lies below the stock price and the option gets knocked out if
the barrier is breached.
❖down-and-in options, where the barrier lies below the stock price and the option gets knocked in only if
the barrier is breached.

➢Each of these categories can be further broken down into whether the concerned option is a call or a put
(it could even be a binary or other exotic option)

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Asian Options
➢Asian options are options in which the payoff to the holder of the option depends on the
average price of the underlying over the life of the contract. The period over which this
average is taken is specified in the contract. It may, for example, be the average daily
closing price over the entire life of the option. Alternatively, it may be the average daily
closing price only over the last month of the option’s life. It may even involve averaging
only over two or three specified time points.
➢Let 𝑆ҧ denote this average price. The most common variety of Asian options is average price
options. In these options, a strike price K is specified in the option contract. At maturity of
the option, the option holder’s payoff is calculated as in a vanilla option but with S playing
the role of 𝑆ҧ. That is, the holder of an Asian average-price call receives the payoff

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Asian Options
➢There is also a class of less popular Asian options called average-strike options in which the
averaging is applied to the strike price instead. That is, 𝑆ҧ plays the role of the strike price in
these options, so the holder of an Asian average-strike call receives the payoff

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Lookback Options
➢Lookback options are options in which the holder may “look back” at maturity and choose
the most favorable price for determining the payoffs. Obviously, which price is the most
favorable depends on whether we are holding a call or a put. In addition, the payoffs are
defined differently depending on whether we are looking at floating-strike lookback
options or fixed-strike lookback options.
➢The more common version of lookback options is the floating-strike option (also
sometimes called the “lookback strike” option). In this case, the strike price for a lookback
call is set equal to the lowest price Smin that was observed during the life of the option.
Thus, the payoff at time T to the holder of a floating-strike lookback call is

➢Note that the “max” is really superfluous since ST – Smin cannot be less than zero.
Analogously, for the holder of a floating-strike lookback put, the strike is set equal to the
highest price that was observed during the life of the option. This results in a payoff at
maturity of

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Lookback Options
➢The other kind of lookback options has a fixed strike price and is also called “lookback
price” options (or, sometimes, “lookforward”) options. In this case, the holder of a call
receives at maturity the payoff

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Shout Options
➢A shout option is like a vanilla European option except that the holder is allowed to “shout”
at one point in the option’s life. At maturity, the holder receives the greater of the intrinsic
value at the shout time or at maturity. That is, if the holder of a shout call option shouts at
time t , the payoff received at maturity is

➢Similarly, the payoff to the holder of a shout put option who shouts at t is

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FINANCIAL GREEKS

FINANCIAL GREEKS

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Option Greeks – How to Measure Risk
➢ What are “The Greeks” : Delta, Gamma, Vega, Theta and Rho..

➢ The Greeks measure the different risks associated with options. The short definitions of these risks are:

▪ Delta : The sensitivity of an option with respect to the underlying moves.

▪ Gamma : The sensitivity of the delta moves with respect to the underlying - second derivative of the option price with respect
to underlying price

▪ Vega : The amount of which an option will change in value with implied volatility moves

▪ Theta : The amount that an option either gains or loses with the passage of time

▪ Rho : The sensitivity of an option price to interest rate changes

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Delta – A Measure of Spot Sensitivity
➢.

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Option Greeks : Delta – A Measure of Spot Sensitivity
Call Delta Example
➢.

Put Delta Example

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Deltas are not fixed
➢.

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Call Delta versus Time
➢.

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Put Delta versus Time
➢.

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Delta as share equivalence
➢.

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Call Delta as Hedge Ratio
➢.

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Delta netting position
➢.

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Gamma: Delta’s Sensitivity to stock price
➢.

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Call Gamma Example Put Gamma Example
➢.

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Gamma is not constant
➢.

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Gamma’s greatest impact
➢.

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Gamma versus Time
➢.

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Gamma netting position
➢.

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Theta: Option value’s sensitivity to time
➢.

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Theta Calculation
➢.

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Time Decay is not constant
➢.

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Theta versus Time
➢.

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Theta versus Volatility
➢.

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Theta netting position
➢.

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Vega: Option value’s sensitivity to volatility
➢.

OR

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Vega example
➢.

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Vega versus Time
➢.

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Vega netting position
➢.

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Rho: Option value’s sensitivity to interest rate
➢.

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Rho versus Time: Example
➢.

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Rho netting position
➢.

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Vanna
➢…

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Volga
➢…

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.
➢.

Volatility Products – VIX

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Volatility Indices : VIX
▪ The VIX is the Chicago Board Options Exchange (CBOE) Volatility Index which measures the implied volatility of the S&P 500
index. It estimates the implied volatility of the S&P 500 over the coming 30 days – hence it is sometimes called the Fear Index.
▪ The idea behind the index is that it can be replicated using a portfolio of options that will not be affected by movements in the
underlying but only by movements in volatility.
▪ VIX is a non-replicable index. However, futures and options are available on VIX.
▪ Other (similar) volatility indices are also constructed: VSTOXX, trading a constant 1 month variance swap on Eurostoxx.

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