New Case

 In the next few days we use as an example the position of a

financial institution that has sold for $300,000 a European
call option on 100,000 shares of a non-dividend paying
stock.
◦ S0 = 49, The Black-Scholes-Merton price of

◦ K = 50, the option is about $240,000 (that is,

$2.40 for an option)
◦ r = 0.05 or 5%,

◦ σ = 0.20 or 20%,

◦ T = 0.3846 or 20 weeks,

◦ Exp return = 0.13

The Black-Scholes Option Pricing Formula

 The price of a call option on a single share of common

stock is:
 C = S*N(d1) – K*e–r(T)*N(d2)

P = Ke–r(T) *N (–d2) – S*N(–d1)

d1 
ln  S K   r  σ 2  
2 (T)
σ (T )
d 2  d1  σ (T )
BSM

Call option premium is = 2.40

BSM

Suppose market price of call

option is 3.00
BSM
NAKED
Strategy
NAKED Strategy
A trading strategy where the seller of an option contract
does not own any, or enough, of the underlying security to
act as protection against adverse price movements.
 Naked trading is considered very risky since losses can be
significant.
 “An options trader could sell, for example, call options with
a strike price of $50. If the stock's price falls to $20 or $30
on bad news, and the option is naked”. So option holder
will suffer losses.
NAKED POSITIONS
 The financial institution has therefore sold the option for
$60,000 more than its theoretical value.

But the problem of

hedging the risks.
NAKED POSITIONS

A naked position is very dangerous.

For example, if after 20 weeks the stock
price is $60, then financial institution have
to take loss of 700000$
COVERED POSITIONS
COVERED
POSITIONS
Sirr by buying 100,000 shares as soon as the
option has been sold we can earn 400000$

And sir I think this is the best strategy

ever 100% profit.
COVERED POSITIONS
 An options strategy whereby an investor holds a 
position in an option and cover position on that same asset
in an attempt to generate increased income from the asset.
 Like “ Writes (sells) call options and holds a long
position in an asset on that same asset.”
COVERED POSITIONS
Okay means we should take cover
positions?
Lets see sold 100000 call option we receive
300000$ and same time we buy 100000
shares @ 49.
If after 20 weeks the stock price is $60
◦ We have to sell 100000@50 means 100000
profit
◦ And 300000 from call premium
◦ Total profit will be 400000$
Seems to be very nice deal
COVERED POSITIONS

Buy, If after 20 weeks the stock price is $30

◦ Then no one will take your shares @ 50
◦ M2M loss will be 2000000 minus 300000
(1700000$)

1700000$ loss
Sirr why don’t you buying one unit of the stock as
soon as its price rises above K and selling it as
soon as its price falls below K

By doing this, if at the end price of stock is

60$ then we have 100000 shares and if
price is 30 $ then we don’t have any shares.
And we can end up with at least 300000$
Stop loss strategy

Here buy and sell are very few.

Just think in real, market fluctuates
infinite time. So we have to buy and
sell infinite time. So again loss.
The answer is…

DELTA HEDGING
Delta

• % Change in call premium due to change in 1 % change in

stock price

• Positive relationship between call premium and stock price

• Delta hedging a written option involves a “buy high, sell

low” trading rule
Delta

• Delta is one of four major risk measures used by

option traders.
• Values range from 1.0 to –1.0
• Call delta values range from 0 to 1.0
• Put delta values range from 0 to –1.0
Long Call Short Call Long Put Short Put
Delta Positive Delta Negative Delta Negative Delta Positive
Delta
Dcall + Dput = 1
 Delta Hedging with Options/Futures
• Delta is slope

• Call Delta = DC= dC/dS D(call) = N(d1)

• Put Delta = DP = dP/dS D(put) = N(d1) — 1

Delta of a portfolio
 Delta of a portfolio is a simple weighted average and the
weight is the quantity (N) of options.
 The delta of the portfolio can be calculated from the
deltas of the individual options in the portfolio.
 If a portfolio consists of a quantity Wi of option i
(1≤i≤n)
 The delta of the portfolio is given by ∆ = ∑wi*∆i (i=1 to
n)
 Where ∆i is the delta of the ith option.
Delta of a portfolio
The formula can be used to calculate the
position in the underlying asset or in a
futures contract on the underlying asset
necessary to make the delta of the
portfolio zero.
When this position has been taken, the
portfolio is referred to as being delta
Delta of a portfolio
 Suppose a Stock broker has the following three
positions
 1. A long position in 100,000 call options (lot size -100)
with strike price 55. The delta of each option is 0.533.
 2. A short position in 200,000 call options with strike
price 56.The delta of each option is -0.468.
 3. A short position in 50,000 put options with strike
price 56.The delta of each option is 0.508.
Delta of a portfolio
 The delta of the whole portfolio is- 100,000 x 0.533 +
200,000 x (-0.468) + 50,000 x (0.508) = -14,900
 This means that the portfolio can be made delta neutral
with a long position of 14,900 with underlying.
 Delta Hedging with Options/Futures

• Call Delta = DC= dC/dS

• From Black-Scholes model,

◦ DC = N(d1) (delta) we can calculate by BSM

◦ S (stock price) = 74.49,

◦ X (strike price)=75,

◦ r (risk free rate) =1.67%,

◦ σ (volatility) =38.4%,

◦ t (time to expire)=0.1589 yrs.

◦ Then, C (call premium)= 4.40

◦ N(d ) = 0.5197
Delta Hedging with Options/Futures

◦ If S increases by $1, C is also increases by $0.5197

◦ Hedge Ratio = H = 1/DC = 1/0.5197 = 1.924

◦ Sell 1.924 calls per share to hedge or sell .5197 stock

per call.
Delta Hedging with Options

Delta changes over time!

◦ Stock price changes
◦ Time to expiration
◦ Other factors like interest rates(r) and volatility
change.
True Delta Hedging
 Suppose we have 1000 IBM shares
 To delta hedge these share we have to sell options
 But how many???
True Delta Hedging
 To know the number of options we first calculate hedge
ratio = 1/delta
 =1/.5197 = 1924 options sell
True Delta Hedging
 IBM stock drops by $1 and we have 1000 shares =

◦ Loss In stock $1000

 Call options premium also drop by $0.5197 (as this is delta)

◦ We have 1924 call short = 1924*.5191= $1000 Profit

 Net P/L = ZERO
 IBM stock rises by $1 = Gain in stock $1000
 Call options also rise by $0.5197 and we have sell position in call
option = 1924*.5191 = - $1000

= Net change 0
Example

• A bank has sold for $300,000 a European call option on

100,000 shares of a non-dividend paying stock

• S0 = 49, K = 50, r = 5%, s = 20%,

• T = 20 weeks, m = 13%
• The Black-Scholes-Merton value of the option is $240,000
• How does the bank hedge its risk to lock in a $60,000 profit?
At Expire, Stock Price less than Strike Price
At Expire, Stock Price More than Strike Price
GAMMA
 The gamma of an option indicates how the delta of an
option will change relative to a 1 point move in the
underlying asset. In other words, the Gamma shows the
option delta's sensitivity to market price changes.

 Gamma is important because it shows us how fast our

position delta will change as the market price of the
underlying asset changes.
GAMMA

In next slide, graph shows Gamma vs Underlying

price for 3 different strike prices.
You can see that Gamma increases as the option
moves from being in-the-money reaching its peak
when the option is at-the-money.
Then as the option moves out-of-the-money the
Gamma then decreases
GAMMA

The Gamma value is the same for calls as for puts.

If you are long a call or a put, the gamma will be a
positive number.

If you are short a call or a put, the gamma will be

a negative number
GAMMA
 When you are "long gamma", your position will become
"longer" (in case of delta hedging) as the price of the
underlying asset increases and "shorter" as the underlying
price decreases.
 Conversely, if you sell options, and are therefore "short
gamma", your position will become shorter as the
underlying price increases and longer as the underlying
decreases
GAMMA

The gamma (G) is the rate of change of the

portfolio’s delta (D) with respect to the price
of the underlying asset.

  2

S 2
 Calculate GAMMA
• From Black-Scholes model,

◦ S (stock price) = 74.49,

◦ X (strike price)=75,

◦ r (risk free rate) =1.67%,

◦ σ (volatility) =38.4%,

◦ t (time to expire)=15.89% yrs.

 GAMMA
Calculation of Gamma

N ' (d1 )

S 0 T
 Calculation of Gamma

d1 
 
ln  74.49 / 75  .0167  0.384 2 2 (.1589)
0.384 (.1589 )
d 2  d1  0.384 (.1589 )

d1  0.049298
d 2  0.049298  0.384 (.1589 )
T

e
K
r

y
b

l
l
a
c

g
n
i
d
n
o
p
s
e
r
r
o
c

d1  0.049298
h
t

f
o

a
t
e
h
t

e
h
t

s
d
e

d 2  -0.10378
e
c
x
e

t
u
p

f
o

a
t
e
h
t

e
h
t

,
)
2

d
(
N
-
1
=
)
2

d
-
(
N

e
s
u
a
c
e
B 
 Calculation of Gamma
1  d 12 / 2
N (d1) 
'
e
2
1 0.049296 2 / 2
N (0.049296) 
'
e
2
1  0.0492962 / 2
N (0.049296) 
'
e
T
0.398862
r

e
K
r

y
b

l
l
a
c

g
n
i
d
n
o
p

N ' (0.049296)  0.398862* 0.998786

s
e
r
r
o
c

e
h
t

f
o

a
t
e
h
t

e
h
t

s
d
e
e
c
x
e

t
u
p

f
o

a
t
e
h
t

N ' (0.049296)  0.398378

e
h
t

,
)
2

d
(
N
-
1
=
)
2

d
-
(
N

e
s
u
a
c
e
B 
 GAMMA
Calculation of Gamma

0.398378

74.49 * .384 .1589

  0.034938
 GAMMA
 Making a portfolio gamma neutral

wT T  
 A delta-neutralportfolio has a gamma equal to Γ
 A traded option has a gamma equal to ΓT

 The number of traded options added to the portfolio is wT

 Calculation of Gamma

N ' (d1 )

S 0 T
GAMMA
Gamma Neutral
 Gamma Neutral Hedging

 The rate of change of the portfolio’s delta with respect to the

price of the underlying asset.
 It is the second partial derivative of the portfolio with respect to
asset price:
• Gamma Neutral Hedging is the construction of options trading
positions that are hedged such that the total gamma value of the
position is zero or near zero, resulting in the delta value of the
positions remaining stagnant no matter how strongly the
underlying stock moves.
 Gamma Neutral Hedging - Introduction

• It prevents the position from reacting to small changes in the

underlying stock.
• It is still prone to sudden big moves which can take option
traders off guard with no time to dynamically rebalance the
position at all.
• By Gamma Neutral, delta value is completely frozen.
Purpose Of Gamma Neutral Hedging

• The main purpose of Gamma Neutral Hedging is to keep

the delta value of a position completely fix no matter how the
underlying stock moves.
• This has 2 purposes;

1. To reduce the volatility of an options trading position by

keeping delta low and stagnant delta.

2. To make a profit from speculating in implied volatility, which is

represented by Options Vega.

 
Delta Positive, Gamma Neutral Example: 

• To keep delta value positive at 0.6 .

• Stock price A is trading at $28.60
• Its May 27.5(strike price) Calls Delta is 0.779 and Gamma is .18

• Its Oct 27.5 (strike price) Calls Delta is 0.697 and Gamma is 0.085.

• To keep delta value positive at .6

• I would short 1 contract of May 27.5 Calls and buy 2 call of Oct 27.

• Position Delta = (0.697 x 2) - (0.779) = 0.615

• Position Gamma = (0.085 x 2) - (0.18) = -0.01 (which is very near

to complete zero and can be regarded as gamma neutral)
Trading Implied Volatility

• Delta Neutral, Gamma Neutral positions perfect for trading volatility.

• The only significant options greek that remains unhedged is the Vega in
a delta neutral, gamma neutral position.

• A delta neutral, gamma neutral position would be long Vega.

• A Completely Gamma neutral position would also have completely zero

theta.
 Delta Neutral, Gamma Neutral Example: 
• Stock A is trading at $28.60 and

• Its May 27.5 Calls have 0.779 delta, 0.024 Vega and 0.18 gamma

• Its Oct 27.5 Calls have 0.697 delta, 0.071 Vega and 0.085 gamma.

• I want delta neutral and gamma neutral while keeping vega positive,

• By taking 5 sets of “short 1 contract of May 27.5 Calls and buy 2 call of
Oct 27.5” and then hedging it by shorting 3 shares of Stock A. 

• Position Delta = ([(0.697 x 2) - (0.779)] x 5) - 3 = 0.075 

(which is very near to zero)

• Position Gamma = ([(0.085 x 2) - (0.18)] x 5) = -0.05 

(which is very near to zero)

• Position Vega = ([(0.071 x 2) - (0.024)] x 5) = 0.59

Example (Real Data)
Delta Neutral, Gamma Neutral
* when Oct undervalued and sept overvalued

Lets understand how we can calculate Delta Neutral, & Gamma Neutral.

On 3rd of sept Delta(oct) = .2274, Gamma(oct) = .0006

Delta(sept) = .1136, Gamma(sept)= .0006

So, I will buy 1 call option of oct month & sell 1 call option of sept month

Then net gamma will be zero (.0006-.0006),

And net delta will be .1138 (.2274 -.1136)

by taking 9 sets of “short 1 contract of Sept 5800 Calls and buy 1 call of Oct 5800”
and then hedging it by shorting 1 Nifty. 

Position Delta = ([(0.2274 x 1) - (0.1137 x 1)] x 9) - 1 = 0.0242

(which is very near to zero)
Position Gamma = ([(0.0006 x 1) - (0.0006)] x 9) = 0
 Delta Neutral, Gamma Neutral
*when Oct overvalued and sept undervalued

Lets understand how we can calculate Delta Neutral, & Gamma Neutral.

On 3rd of sept Delta(oct) = .2274, Gamma(oct) = .0006

Delta(sept) = .1136, Gamma(sept)= .0006

So, i will sell 1 call option of oct month & buy 1 call option of sept month

Then net gamma will be zero (.0006 -.0006),

And net delta will be -.1138 (-.2274 +.1136)

by taking 9 sets of “short 1 contract of Oct 5800 Calls and buy 1 call of Sept 5800”
and then hedging it by long 1 Nifty. 

Position Delta = ([(-0.2274 x 1) + (0.1137 x 1)] x 9) + 1 = -0.0242

(which is very near to zero)
Position Gamma = ([(0.0006 x 1) - (0.0006)] x 9) = 0
Cont….
Delta Neutral, Gamma Neutral when Oct overvalued and sept
overvalued :

Then we will sell high over valued and buy low overvalued.

Delta Neutral, Gamma Neutral when Oct undervalued and sept

undervalued :

Then we will sell less undervalued and buy large undervalued.

Cont….
So total exposure is = ([(57.85 x 1) - (17.2 x 1)] x 9) = 365.85

And 1 nifty sold @ 5341.45

Suppose price of nifty moves to 5500 on same day

Then new value of call option of Oct month is 104.1388 and Sept month is
46.64 (assuming same implied volatility)

So new total exposure is = ([(104.1388 x 1) - (46.64 x 1)] x 9) = 517.4892

Loss in nifty futures = (5341.45 – 5500) = 158.55

Combined exposure is 517.4892 – 158.55 = 359.

Difference is 7
 Case 2
On Sept 16 ,how we can do Delta Neutral, & Gamma Neutral.

On 16th of sept Delta(Oct) = .5906, Gamma(oct) = .0007

Delta(sept) = .5787, Gamma(sept)= .0013

So, i will buy 13 call option of oct month sell 7 call option of sept month

Then net gamma will be zero

And net delta will be = ([(0.5906 x 13) - (0.5787 x 7)] ) = 3.6269

by taking 8 sets of “short 7 contract of Sept 5800 Calls and buy 13 call of Oct
5800” and then hedging it by shorting 29 Nifty. 

Position Delta = ([(0.5906 x 13) - (0.5787 x 7)] x 8) - 29 = 0.0152

(which is very near to zero)
Position Gamma = ([(0.0007 x 13) - (0.0013 x 7)] x 8) = 0
Cont….
So total exposure is = ([(265.8 x 13) - (151.15 x 7)] x 8) = 19178.8

And 29 nifty sold @ 5840.55

Suppose price of nifty moves to 6000 on same day

Then new value of call option of Oct month is 368.9 and Sept month is
258.58 (assuming same implied volatility)

So new total exposure is = ([(368.9 x 13) - (258.58 x 7)] x 8) = 23885.12

Loss in nifty futures = (5840.55 – 6000) x 29 = 4624

Combined exposure is 23885.12 – 4624 = 19261.

Difference is 82
That’s all for this time!!!