Volume 7, Issue 4 (April, 2018) UGC APPROVED Online ISSN-2277-1166

Published by: Abhinav Publication

Abhinav National Monthly Refereed Journal of Research in
Commerce & Management
A STUDY ON RISK HEDGING STRATEGY: EFFICACY OF
OPTION GREEKS
Arya Kumar
Research Scholar
IBCS, Siksha ‘O’ Anusandhan, (Deemed to be University)
Email:[email protected]

ABSTRACT
Financial Derivatives are innovative instruments in the financial market. Derivatives have a great
deal of use in risk management. A judicial use of derivatives in right proportion enables a corporate
manager to minimize risk and optimize return. Basically, there are four categories of derivatives i.e.
Forward, Futures, Options, and Swaps. In India, futures and options are commonly used. In option
derivative, the premium which is paid by the option holder to the option writer is known as option
premium or option price. For determining the theoretical price of the option, the most appropriate
model i.e. Black Scholes option pricing Model. This option pricing model is well accepted throughout
the world. If the theoretical price of an option contract deviates significantly from its actual price, then
the financial market will be seriously disturbed. This paper studies the efficacy of commonly used
Greeks such as Delta, Gamma, Theta, Vega, and Rho and their significance in managing various types
of risks associated with an option contract. Further these five Greeks are taken only for European
Option within the Black Scholes Model framework. The scope of the study covers monthly option
pricing and Greeks of ITC, HDFC and RELINFRA for the month of January 2017. Lastly, an attempt
has been made to explore the implication of these Greeks for managing the risk associated with an
option contract.
Keywords: Derivative, Risk Management, Option Pricing

INTRODUCTION
Corporate risk management is the management of unpredictable events that would have adverse
consequences for the firms. In the financial market, the players may face financial risk exposures such
as Price exposure (asset price exposure), foreign rate exposure, interest rate exposure and inflation rate
exposures etc. Derivatives are a specific type of instruments that derive their value over time from the
performance of underlying assets i.e. equities, bonds and commodities for hedging the financial risk.
In the world of finance, we find four types of derivatives in the name of Forwards, Futures, Options,
and Swaps. Derivatives may be categorized as “Over The Counter (OTC) Derivatives” and “Exchange
Traded Derivatives”. Option derivative is prevailing globally as it can be traded in OTC market as well
as Exchange Traded market. Banks, Financial Institutions, Mutual Funds, Corporations, Individual
Investors and Pension Administrators use option derivatives to hedge the various kinds of exposures in
their financial dealings.
Through research evidence and practices, few models have been developed globally to determine the
theoretical price (price of the option is determined by using certain factors as well as certain models)
of the option. Essentially the difference between the theoretical price of the option and the price which
is actually paid (actual premium paid by the option holder to option the writer) by the holder in real
practice should not be significant. In case the difference is highly significant, then the financial market

Available online on www.abhinavjournal.com 77

 Abhinav National Monthly Refereed Journal of Research In
Commerce & Management
of a country will be under stress. The factors which influence the value of an option are the current
price of the underlying assets, Strike Price, Time to Maturity, Volatility of the Underlying Security
Price and Risk-Free Interest.
Option trading means buying and selling option. The principle of options trading is to maximizepayoff
or minimizes potential risk looking at the stock market behavior. The options trader should be
knowledgeable in measuring various categories of risks associated with trading. Through mathematical
formulae, certain numbers are generated to measure these risks. Collectively these numbers are titled
as Option Greeks. These option Greeks are named as Delta (∆), Gamma (γ), Theta (θ), Vega (ν) and
Rho (ρ).
OBJECTIVE OF STUDY
1. To examine the impact of various determinants on option price.
2. To make an in-depth study of risk hedging strategies with options.
3. To suggest the risk management strategy through option contracts.
RESEARCH QUESTION
The option contract in financial derivative plays a crucial role in hedging the risk by minimising the
volatility. Identifying the actual price of any contract will help to reduce the chances of risk for an
individual, business firms and corporate houses. Past research states that common people are unaware
about the price discovery or risk hedging technique through option contract. Hence, this paper will
highlight the following research question “How to calculate the prices of option contract and hedge the
risk by considering all the determinants?”
LITERATURE REVIEW
1. Ms. Shalini and Dr. Raveendra, (2014). Derivatives are tool for managing risk and the growth of
derivatives in the recent years has surpassed the growth of its counterpart globally.
2. Fischer Black and Myron Scholes (1973). An empirical test made and observed option buyers
pays more than that is predicted through formulas as there is larger transaction costs in option
market.
3. Hemal Thakker and& A.A Attarwalla (2016), the analysis is done to identify that price discovery
is possible through binomial option pricing model. The result states that the market value of Nifty
option pricing and Binomial option pricing model is significantly different from each other.
4. Thomas F. Coleman,Yohan Kim,Yuying Li and Arun Verma (2001), the volatility smile is
derived out of the implied volatility. Though this ensures integrity of valuation, it distorts the
delta and other Greeks because using the implied volatility cannot ensure integrity of Greeks.
Thus there is a volatility smile adjustment to be made to the Greeks, especially Delta, because we
use this Greek to spot hedge.
5. Shonkle M. Bartam (2006), Use of option as a risk management tool by non-financial firms.
Consider accounting treatment of derivatives and liquidity effects for determining the derivative
instruments.
6. Midhula Mohan K. and A.V. Hemalatha (2016) the financial derivative in recent trend has shown
a highest growth in financial market. The result states that most of the private and government
sector are engaged in derivative trading rather than post office saving, FD or LIC. However,
common people are not aware which can be done through the broker and exchanges.
7. Yuh-Dauh Lyuu. Huei-Wen Teng, (2011), Risk hedging through Option Greeks is observed to be
less variate from the actual result this help for predicting by using various formulas numerically
which are unbiased.

VOL. 7, ISSUE 4 (April, 2018) 78 Online ISSN 2277-1166

 Abhinav National Monthly Refereed Journal of Research In
Commerce & Management
8. Luis H. Ederington and Wei Guan, (2007). There are other higher order derivatives can be
considered. Particularly important in accounting for option price changes delta and others also has
the role, but gamma has gained all kind of popularity.
RESEARCH METHODOLOGY
In the study, the data covers European Option price (both call and put). This data are selected for a
period of one month i.e. Jan 2017. The three companies i.e. HDFC (financial sector), ITC (FMCG
sector) and RELINFRA (Power generation sector) have been selected from convenience sampling.
OPTION DERIVATIVE – A CONCEPTUAL FRAMEWORK
Options are contracts which provide the holder the right to sell or buy a specified quantity of an
underlying asset at a fixed price on or before some point of time in future. The options can be
classified into call option and put option. “The call option is one where the option buyer has a right to
buy (call) the asset while a put option is one where the option buyer has right to sell(put) the asset
before the writer”. The option holder has to pay a premium to the option writer for availing the right.
Style of Exercise of Option
In Derivative finance, the style of an option denotes the date on which the option may be exercised by
the holder. Depending on when an option can be exercised it can be classified into following
categories:
1. American style Option or American option: in this style, the option can be exercised by the option
holder at any time during the life of the contract, i.e., on or before the expiration date. Thus, in an
American style, the option holder has right to exercise his right to buy/sell any time before the
expiry date.
2. European Style Option or European Option: In this style, the option may be exercised only on the
expiry date of the option, i.e., at a single pre-defined point in time.
In options trading CA represents Call option American style, CE represents Call Option European
Style, PA represents Put option American style and PE represents Put Option European Style. Besides
the common term Long means to buy while short means to sell.
The position of an option trader
The position of an options trader may be the buyer of the call, the buyer of the put, the seller of a call
or seller of a put. When we analyze any financial transaction through option contract (European Style)
we find the following results:
Option On the date of option contract At Expiration of the option contract
Position
Let X = Strike Price, ST = Market Price of the
underlying asset
Buyer The option holder pays a • If ST > X, the option holder exercises the
(Holder) of a premium and acquires the right to option. Then Gross pay-off = ST - X and Net
call:(Long buy the underlying asset at the Profit = ST – X – Premium.
call) --> Right strike price on the expiration date.
• If ST < X, the option holder does not exercise
to buy
the option, then Net Profit = Zero – Premium.
Buyer The option holder pays the • If ST < X, the option holder exercises the
(Holder) of a premium and acquires the right to option. Then Gross pay-off = X – ST and Net
put:(Long sell the underlying asset at the Profit = X – ST - Premium.
put) ---> strike price on the expiration date.
• If ST > X, the option holder does not exercise
Right to sell
the option, then Net Profit = Zero – Premium.

VOL. 7, ISSUE 4 (April, 2018) 79 Online ISSN 2277-1166

 Abhinav National Monthly Refereed Journal of Research In
Commerce & Management
Seller The option writer receives the • If ST > X, the option holder exercises the
(Writer) of a premium and commits to deliver option, then Net Loss = (X – ST) + Premium. •
call:(Short the underlying asset at the strike If ST < X, the holder does not exercise the
call) ---> price on the expiry date if the option. Then, Net Profit = Premium.
Obliged to holder exercises the option and
sell demands the delivery.
Seller The option writer receives the • If ST < X, the option holder exercises the
(Writer) of a premium and commits to buy and option. Then Net Loss = (ST – X) + Premium.
put:(Short take delivery of the underlying
• If ST > X, the holder does not exercise the
put) --> assets at the exercise price on the
option. Then, Net Profit = Premium.
Obliged to expiration date if the holder
buy exercises the option and give
delivery of the underlying.

The impact of determinants on option price- A practical approach

Option strategy is a zero-sum game, so the option premium paid (transaction value of the option)
should not significantly differ from the theoretical value of the option. To determine the theoretical
value of the option six factors are to be considered. These determinants are the Spot price of the
underlying asset (S), Strike Price (X), Time till Expiration (T), Expected Volatility (σ), Risk-Free
Interest Rate (r) and Expected Income/ Dividend (D).
The Following table shows the effect of the price of an option when one of the determinants increases
keeping other five determinants as constant.
Determinant of Option Price Increase Call Option Put Option
Price Price
Spot price of underlying asset (S) ↑ ↑ ↓
Strike Price (X) ↑ ↓ ↑
Time till Expiration (T) ↑ ↑ ↑
Expected Volatility (σ) ↑ ↑ ↑
Risk-Free Interest Rate (r ) ↑ ↑ ↑
Expected Income/ dividend (D) ↑ ↑ ↓
The above-stated determinants of option pricing and their respective implications can be put in the
following model:
Option Moneyness: At- the -Money (ATM), In -the -Money (ITM), Out –of- the- Money (OTM)
A call option gives the holder the right to buy at the exercise price while a put option gives the holder
the right to sell at the exercise price. At a particular time, the underlying may be greater, equal or lesser
than the Exercise Price. In such situations, the options are said to be at-the-money (ATM) or in-the-
money (ITM) or out-of-the-money (OTM). These situations are as shown below:
Call Option Option is said to be Put Option
Exercise Price= Market Price At- the -Money Exercise Price= Market Price
Exercise Price< Market Price In -the -Money Exercise Price>Market Price
Exercise Price> Market Price Out –of- the- Money Exercise Price<Market Price

VOL. 7, ISSUE 4 (April, 2018) 80 Online ISSN 2277-1166

 Abhinav National Monthly Refereed Journal of Research In
Commerce & Management
Risk Hedging strategies by using option Greeks
Price of a call option or put option on non-dividend paying asset is a function of five variables namely
the Spot price of the underlying asset (S), Strike Price (X), Time Till Expiration (T), Expected
Volatility (σ), Risk-Free Interest Rate (r ). If there is any change in any variable or determinant during
the option contract, its effect will be on option price. In case the effect is negative, then the options
trader will be at risk. Through mathematical formulae, certain numbers are generated to estimate these
risks. Collectively, these numbers are known as “Greeks”. In this paper, we have discussed five Greeks
namely Delta (∆), Gamma (γ), Theta (θ), Vega (ν), Rho (ρ).Each Greek letter of an option measures
the sensitivity of an option price with respect to change in the value of a given underlying parameter
such as underlying asset price.
Efficacy of Greeks in option trading
1. Option Delta- it helps to analyze that how sensible is option price towards the change in
underlying assets.
2. Option Gamma-it response to the change in option delta that leads to change in the value of stock
price. Gamma tends to rise if underlying assets is close to expiration.
3. Option Vega- It considers the implied volatility that affects the price of the stock. Implied
volatility refers to market’s estimation which is calculated by the standard deviation. So higher
the volatility higher will be the sensitivity of option.
4. Option Theta-It considers the time of expiry i.e. lesser the time of expiry lesser will be the option
pricing. In such case to earn a good amount of profit the option needs to be sold at right time.
5. Option Rho- It considers the interest rate that is available in the market. As the rate of interest is
usually fixed for a long period of time so the use of Rho is very less. But Rho is very useful for
the underlying assets that are meant for long term.
Option Greeks: Concept, Derivation and Modelling Approach
Greeks Call Option Put Option Values
Option ∂C ∂P Where, ∂ = Partial Derivative, C= Call option
Delta (∆) Price, S= price of the underlying asset, P= Put
∂S ∂S
option price
Option ∂ ∆ = ∂2 C ∂ ∆ = ∂2P Where, γ = Gamma, ∆ = Option Delta, S= Stock
Gamma (γ) Price, C= Call option Price, P= Put option price
∂S ∂ S2 ∂S ∂ S2
Option ∂C ∂P Where, ∂ = Partial Derivative, C= Call option
Theta (θ) Price, t= time till expiration, P= Put option price
∂t ∂t
Option ∂C ∂P Where, ∂ = Partial derivative, P= Put option price,
Vega (ν) C= Call price, σ = volatility
∂σ ∂σ
Option Rho ∂ C ∂P Where, ∂ = Partial derivative, P= Put option price,
(ρ) C= Call price, r = Risk-free interest rate
∂r ∂r

VOL. 7, ISSUE 4 (April, 2018) 81 Online ISSN 2277-1166

 Abhinav National Monthly Refereed Journal of Research In
Commerce & Management
OPTION GREEKS COMPUTATIONAL PROCEEDURE: EXAMPLES
1. Call Option Greeks- A Numerical Example
Inputs
Strike Price (Rs) Spot Price (Rs) Time (Days) Volatility (%) Interest (%) Type
175 170 34 25 10 Call Option
Results
Price (Rs) Delta Gamma Theta Vega Rho
3.74 0.4130 0.0300 -33.7560 20.2016 6.1920

Option Value = 3.74

This is the theoretical price of the option or the option premium in Rs.
Delta = 0.4130
If the share price or the underlying changes by a small amount, then the option price should change by
0.41 times of that amount. A negative sign would indicate a decrease in option price, whereas positive
sign would indicate an increase in the option price. In this case if the underlying changes by Rs 1 or 1
point the option price should change by 0.41 times of the change.
Therefore, the premium should change by 0.41 * 1 = 0.41 Rs.
Gamma = 0.0300
If the share price changes by a small amount, then the delta should change by 0.0300 times that
amount. If the underlying share price or index is increased by 1, then the delta should change by
0.0300
Theta = -33.7560
If the time to maturity changes by a small amount, then the option value should change by -33.7560
times that amount. As we have 365 days in the year. A decrease of one day would mean a change of
0.2739% of a year, therefore, the option value should change by 0.002739 * -33.7560 = -0.0925. The
negative sign indicates a decrease in option price.
Vega = 20.2016
If the volatility changes by a small amount, then the option value should change by 20.2016 times that
amount.
If the volatility increased by 0.01 (1%), then the option value should change by 0.01 * 20.2016 =
0.0003
Rho=6.1920
If the interest rate changes by a small amount, then the option value should change by 6.1920 times
that amount. A negative sign would indicate a decrease in the option price. If the interest rate is
increased by 0.01 ( 1%), then the option value should change by 0.01 * 6.1920 = 0.0619 .

VOL. 7, ISSUE 4 (April, 2018) 82 Online ISSN 2277-1166

 Abhinav National Monthly Refereed Journal of Research In
Commerce & Management
2. Put Option Greeks- A Numerical Example
Inputs
Strike Price (Rs) Spot Price (Rs) Time (Days) Volatility (%) Interest (%) Type
175 170 34 25 10 Put
Option
Results
Price (Rs) Delta Gamma Theta Vega Rho
7.12 -0.5870 0.0300 -16.4183 20.2016 -9.9582

Option Value = 7.12

This is the theoretical price of the option or the option premium in Rs.
Delta = -0.5870
If the share price or the underlying changes by a small amount, then the option price should change by
-0.59 times of that amount. A negative sign would indicate a decrease in option price, whereas positive
sign would indicate an increase in the option price. In this case if the underlying changes by Rs 1 or 1
point the option price should change by -0.59 times of the change.
Therefore, the premium should change by -0.59 * 1 = -0.59 Rs.
Gamma = 0.0300
If the share price changes by a small amount, then the delta should change by 0.0300 times that
amount. If the underlying share price or index is increased by 1, then the delta should change by
0.0300
Theta = -16.4183
If the time to maturity changes by a small amount, then the option value should change by -16.4183
times that amount. As we have 365 days in the year. A decrease of one day would mean a change of
0.2739% of a year, therefore, the option value should change by 0.002739 * -16.4183 = -0.0450. The
negative sign indicates a decrease in option price.
Vega = 20.2016
If the volatility changes by a small amount, then the option value should change by 20.2016 times that
amount.
If the volatility increased by 0.01 (1%), then the option value should change by 0.01 * 20.2016 =
0.0003
Rho = -9.9582
If the interest rate changes by a small amount, then the option value should change by -9.9582 times
that amount. A negative sign would indicate a decrease in the option price. If the interest rate is
increased by 0.01 0 (1%), then the option value should change by 0.01 * -9.9582 = -0.0996.
1. Option Greeks-An Empirical Analysis:
Financial Derivative tends to fluctuate due to several factors beyond the change in prices of underlying
assets. To maintain a healthy portfolio with fewer chances of risk an investor should manage the
expected risk by applying Greek characters based on such the investor can take a decision that whether
to buy or sell the option contract.

VOL. 7, ISSUE 4 (April, 2018) 83 Online ISSN 2277-1166

 Abhinav National Monthly Refereed Journal of Research In
Commerce & Management
Information ITC RELINFRA HDFC
Today 02/01/2017 02/01/2017 02/01/2017
Maturity 25/01/2017 25/01/2017 25/01/2017
Strike Price 265 500 1300
Stock Price 240.95 478.7 1217.1
Dividend 0 0 0
Int Rate 0.0619 0.0619 0.0619
Volatility 0.2090 0.1971 0.2161
Calendar 17 17 17
Years 0.06746 0.06746 0.06746
Shares 100 100 100

Graphs Showing the Stock price and Strike price of the companies for a period of one month

1350
HDFC
1300
1250
1200
1150

STRIKE PRICE
CLOSING STOCK PRICE

From above calculations and graph, we got a clear picture that how well Greeks characters help to
understand the risk and return of option contract, that an investor can take the right decision. We
considered three companies namely ITC (FMCG), RELINFRA (Power and Distribution) and HDFC
(Finance). HDFC and ITC show out the money i.e. the price of the stock less than the price of the
strike. These stocks are a high risk that makes them less expensive. An investor if prefer to accept this
stock due to less expensive then he/she is making its portfolio very risky. In contrary, the stock price is
found a bit more than the strike price in case of Reliance infrastructure which makes it less risky and
hence attracts many investors.
SUGGESTIONS
1. For any options trading, an investor must consider the sensitivity of the option
2. The investor should take the position of a call option writer or put option holder in the bearish
market to hedge the financial risk.
3. In the bullish market, the investor should be a call option holder otherwise if they take the
position of call option writer then you will incur more losses. Similarly in the same bullish

VOL. 7, ISSUE 4 (April, 2018) 84 Online ISSN 2277-1166

 Abhinav National Monthly Refereed Journal of Research In
Commerce & Management
market, one should take the position put option writer otherwise if they take the position of put
option holder, then they will suffer financial losses.
4. Regular awareness programme should be conducted by SEBI, NSE, BSE, and MCX, NCDEX
(Use of Option and Future Derivatives) for the investors in India.
5. SEBI being the regulator of security market should introduce strategic measures for boosting
derivative segment in India as a technique of hedging.
CONCLUSION
This article presents a simple way to understand option derivative, the determinants of option pricing
models and also the concept of moneyness in options trading. The five option Greeks for European
options under the Black Scholes model have been studied with respect to their individual potentiality.
To make the derivative market more strong the players should have right kind of knowledge in
understanding these Greeks and their judicious applicability for hedging any kind of adverse exposure.
FUTURE STUDY
The paper tries to focus on giving basic idea on Option Greeks as it is one of the complicated contracts
in financial derivative. The analysis is done for one month considering three sectors as the calculation
required a statistical tool to measure the vast data. However, a researcher or an investor can calculate
different sector in following ways so as to identify how to hedge the risk in option contract.
REFERENCES
1. Black, F., & Scholes, M. (1973). The Pricing of Options and Corporate Liabilities. Journal Of
Political Economy, 81(3), 637-654. http://dx.doi.org/10.1086/260062
2. Paunovic, J. (2014). Options, Greeks, and risk management. Singidunum Journal Of Applied
Sciences, 11(1), 74-83. http://dx.doi.org/10.5937/sjas11-5820
3. Mohan K, M., & Hemalatha, A. (2016). A Study on Awareness About Investment In Derivatives
Among Government Employees In Calicut District Of Kerala. Abhinav International Monthly
Refereed Journal Of Research In Management & Technology, 5(2), 1-8.
4. Prakashyalavatt , 2015 “A study on strategic growth in India financial derivatives market”,
International Journal of Recent Scientific Research, vol. 6, Issue, 10, pp. 6589-6593
5. Chen, R., & He, W. (2015). The Valuation of Compound Options: A Correction and an Extension.
The Journal Of Derivatives, 22(4), 92-104. http://dx.doi.org/10.3905/jod.2015.22.4.092
6. Sanjana Juneja, 2013. Understanding the Greeks and their uses to measure risk, International
Journal of Research in Commerce, IT and Management, 3(10).
7. Thakker, H., & Attarwala, A. (2016). Testing the Efficiency Of The Binomial Option Pricing
Model In The Indian Equity Options Markets For The Period 2010 To 2015 Using The Nifty
Option. Abhinav National Monthly Refereed Journal Of Research In Commerce & Management,
5(11), 29-36.
8. Yamin Li and Geral Salkin, 2002, “Hedging option portfolios without using Greeks”, Derivatives
Use, Trading & Regulation, ABI/Inform Global, page 362.
9. Swain P.K.- 2012 “ Fundamental of financial derivatives”, 1st edition. HPH Pvt. Ltd.
10. Varma J. R. 2010 “Derivatives and Risk Management, 3rd Edition. Mc. Graw Hill Education Pvt
Ltd.

VOL. 7, ISSUE 4 (April, 2018) 85 Online ISSN 2277-1166