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Option Risks

The following video is borrowed from the Certified Hedge Fund Professional training program and covers option risks.  This video explains what is option risks and covers the delta, the gamma, the vega, the theta, the correlation and the strike map.

Video TranscriptThe strategies and tips provided within this video module include:

In this short video, we will discuss options risk. We will define each risk and how this affects a portfolio of options along with a brief description of how to hedge these types of risks. The risks that will be discussed are “The Delta” “The Gamma” “The Vega” “The Theta” correlation risk within options and strike map risk. The Delta is the theoretical directional exposure an investor has to an underlying asset. Delta is generally measured in percentage terms which is then converted into shares or contracts. For example, the delta of an after money call option is approximately 50% on one options contract which is 100 shares. The theoretical exposure to any movement in the underlying market is 50 shares. A $1 move in either direction leaving all other factors unchanged would create a penal of $50 or minus $50.

The delta of an option moves to one as a call goes deep in the money. It moves to zero as a call goes deep out of the money. When trading options the delta is usually the largest and most sensitive risk. For portfolio manager and risk managers, tracking directional risk, the delta is generally the most important factor. To hedge the delta of an option, an investor can either initiate an offsetting position in the underlying shares, contracts or use other options. For example, if an investor purchased one option of an apple that was at the money, the investor could hedge the delta by shorting 50 shares of apple stock.

Gamma risk, deals with the second-order effect for options. Gamma is the first derivative of the delta and is used when trying to gauge the price of an option relative to the amount it is in or out of the money. Gamma not only affects the price of an option but additionally the delta of the option, the higher the gamma of the option, the greater the change in the delta relative to any underlying movement in the price of underlying assets. Positive gamma risk generally is associated with long options positions while negative gamma risk is associated with short options positions. The second-order can quickly change giving definite strike prices of options within a portfolio and as an important risk for portfolio managers to understand.

In practical terms, positive gamma will produce increases in delta as the market moves higher. So if you started at, at the money and the market moved higher, the gamma would increase the number of shares from 50 to 60. The same would occur if you had positive gamma on the downside. If you started with 50 shares and the market moved lower, your gamma would decrease the number of shares you had theoretically from a delta of 50 to a delta of 40. And investor receives the benefit of gamma by purchasing options which requires an investor to pay premium which also equals the value of an option. Investors can hedge their gamma by buying and selling options.

The next order of risk is volatility or vega risk. The volatility or vega risk of a financial security is also known as implied volatility of a portfolio. The vega of a portfolio is the change in the value of a portfolio due to the perceived change and how much the financial instrument will move over the course of time. Implied volatility is a measurement used in the pricing evaluation of options and it is generally quoted in percentage terms. Vega is generally reported as a dollar figure for 1% move of implied volatility. To hedge vega, investors need to use options to mitigate this risk. Long option positions create positive vega while short options positions create negative vega.

Theta is the Greek term for time decay and represents risks relative to time. The decay of time for a long position is not linear and therefore time decay grows more quickly as an option approaches expiration. The theta of a portfolio shows the amount of dollar gain or loss from one day of holding the securities in a portfolio.

Correlation risk comes from exotic options such as spread options which have exposure of a portfolio to the correlation of these options and are priced and valued using the relative correlation as an input parameter. The options are sensitive to the change in the underlying correlation of one security relative to another. This risk in embedded into the pricing of specific types of options. The hedge — to hedge this type of risk, an investor needs to buy or sell similar types of options.

Lastly, we will discuss strike risk or strike map risk which is a measurement of the exposure to a specific prices across a portfolio. This concept allows a trader to understand specific exposure as prices move up and down a price scale. Each price might generate positive or negative delta, gamma and vega as the financial instrument moves up and down the price scale. When risk limits are calculated in an option portfolio, a risk manager needs to understand not only the current risks but what could occur if the market moves to another strike price.

For example, you might have in a specific tenor bucket say, three months, a short call at $25 on a security and a long call at $20. As the market moves higher in price away from the long call and to the short call, the positive gamma and vega that is received will change to negative gamma and vega as the market continues higher. The risk manager also needs to be aware of other tenor buckets which will create positive and negative gamma. Along put, as the market goes a little slower will become less and less positive gamma and negative — positive gamma along put will become less positive gamma and vega and more short gamma and vega as the market goes lower.

Strike map risk requires the risk manager to look at all the strikes within a portfolio to understand the relative risks as the markets begin to move.

I hope you that this video better explained option risks, the delta, the gamma, the vega, the theta, the correlation and the strike map. 

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