Meet this gentleman!!!

He is
struggling
with … a
problem

He is a derivative trader. 
Meet this gentleman!!!
He want to
buy gold @
30000 but
he is afraid
that the
prices may
fall after
buying
He is a derivative trader. 
 Buy a call
option

Teacher 
After this he was very
happy
After some time……
After some time……
He is still upset
At what price
Pricing of options is not easy
Which model is 
better 
binominal or 
BSM
OPTION PRICING
OPTION PRICEING

Black–Scholes model(BSM)
The Black-Scholes Option Pricing Model

 The Black-Scholes option pricing model says the value of

a stock option is determined by five factors:

 S, the current price of the underlying stock.

 K, the strike price specified in the option
contract.
 r, the risk-free interest rate over the life of
the option contract.
 T, the time remaining until the option
contract expires.
 , (sigma) which is the price volatility of the
underlying stock.
The valuation formula
Assumption for the BSM for value of an option.

1. Short term interest rate is known and is constant.

2. The stock price follows a random walk and distribution of possible
stock prices at the end of any finite period is log- normal.
3. Variance rate of return on stock is constant.

4. No dividend or other distribution.

5. Option is European.
6. No transaction costs.

7. Can borrow any fraction of the price of a security to buy it or hold it, at
the short term interest rate.
8. No penalties on short selling.
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)

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

stock is:
 P = Ke–r(T) *N (–d2) – S*N(–d1)

 d1 and d2 are calculated using these two formulas:

d1 
 
ln S K   r  σ 2 2 (T)
σ (T )
d 2  d1  σ (T )
N (x)
N (x) denotes the cumulative probability

distribution function for a standardised normal

distribution (mean = 0, standard deviation = 1).

In addition, the formula makes use of the fact that:

N(-d1) = 1 - N(d1)
Standard normal probability
 For example, To find the cumulative probability of a z-score
equal to -1.31, cross-reference the row of the table containing
-1.3 with the column containing 0.01. The table shows that the
probability that a standard normal random variable will be less
than -1.31 is 0.0951; that is, P(Z < -1.31) = 0.0951.
Example: Computing Prices for Call and Put Options

 Suppose you are given the following inputs:

S = $50
K = $45
T = 3 months (or 0.25 years)
s = 25% (stock volatility)
r = 6%
 What is the price of a call option and a put option, using the
Black-Scholes option pricing formula?
We Begin by Calculating d1and d2

d1 
  
 
ln  S K   r  σ 2 2 T ln  50 45  0.06  0.252 2  0.25
σ T 0.25 0.25

0.10536  0.09125 0.25


0.125

 1.02538

d 2  d1  σ T  1.02538  0.25 0.25  0.90038

Now, we must compute N(d1) and N(d2). That is,

the standard normal probabilities.
Using the =NORMSDIST(x) Function in Excel

 If we use =NORMSDIST(1.02538), we obtain 0.8474.

 If we use =NORMSDIST(0.90038), we obtain 0.8160.

 Let’s make use of the fact N(-d1) = 1 - N(d1).

N(-1.02538) = 1 – N(1.02538) = 1 – 0.8474 = 0.1526.

N(-0.90038) = 1 – N(0.90038) = 1 – 0.8160 = 0.1840.

 We now have all the information needed to price the call

and the put.
The Call Price and the Put Price:
 Call Price = SN(d1) – Ke–rTN(d2)

= $50 x 0.84741 – 45 x e-(0.06)(0.25) x 0.81604

= 50 x 0.84741 – 45 x 0.98511 x 0.81604

= $6.195.

 Put Price = Ke–rTN(–d2) – SN(–d1)

= $45 x e-(0.06)(0.25) x 0.19479 – 50 x 0.15259

= 45 x 0.98511 x 0.18396 – 50 x 0.15259

= $0.525.
Valuing the Options Using
Excel
Valuation of Currency Options
 European Call Option

◦ C = S x e-rf x T x N(d1) – K x e–r(T) x N(d2)

 rf is the continuously compounded risk-free foreign
currency interest rate
r is the continuously compounded risk-free local currency
interest rate
d1 
 
ln S K   (r - rf)  σ 2 2 (T)
σ (T )
d 2  d1  σ (T )
Valuation of Currency Options

 European Put Option

◦ P = Ke–rT x N(–d2) – S x e-rf x T x N(–d1)

Que
 Suppose USD =Rs. 50. (SPOT)
 A 3-M option on USD has exercise price of Rs. 52. (K)
 It has annual volatility of 15%.
 Continuously compounded risk-free rupee rate is 8% p.a.
(r)
 Dollar rate is 3% p.a. (rf)
 What would be its price as per Black Scholes model, if it
is an European Call?
Answer

d1 
  
 
ln  S K   r  σ 2 2 T ln  50 / 52  (0.08 - 0.03)  0.152 2  0.25
σ T 0.15 0.25

- 0.03922  0.06125  0.25


0.075

 - 0.31878

d 2  d1  σ T  -0.31878  0.15 0.25  -0.39378

Using the =NORMSDIST(x) Function in Excel
 NORMSDIST(-0.31878), we obtain 0.374948
 NORMSDIST(-0.39378), we obtain 0.346873 .

 Let’s make use of the fact N(-d1) = 1 - N(d1).

N(-d1) = 1 – 0.374948 = 0.625052
N(-d2) = 1 – 0.346873 = 0.653127 .
The Call Price and the Put Price:
 Call Price = S x e-rf x T x N(d1) – K x e–r(T) x N(d2)

= 50 x 0.992528 x 0.374948 – 52 x 0.980199 x 0.346873

= 49.6264 x 0.374948 – 50.97033 x 0.346873

= 0.927086.

 Put Price = Ke–rT x N(–d2) – S x e-rf x T x N(–d1)

= 52 x e-(0.08)(0.25) x 0.653127 – 50 x e-(0.03)(0.25) x 0.625052

= 52 x 0.980199 x 0.653127 – 49.6264 x 0.625052

= 2.271017.
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,

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

◦ σ = 0.20 or 20%,

◦ T = 0.3846 or 20 weeks,

◦ Exp return = 0.13

Que 1
Suppose a stock, trading at Rs. 20, has annual volatility
of 15%. A 3-month option on that stock has exercise
price of Rs. 17. Continuously compounded risk-free rate
is 8% p.a. What would be its price as per Black Scholes
model, if it is an European Call?
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
 Thefinancial 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 Delta
Delta Positive Delta Positive
Negative Negative
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 0.56.The delta of each option is -0.468.
 3. A short position in 50,000 put options with strike
price 0.56.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(d1) = 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

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e
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d 2  -0.10378
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 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
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b

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N ' (0.049296)  0.398862* 0.998786

s
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N ' (0.049296)  0.398378

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 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)
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!!!