#### Pierino Ursone

Introduction

The most widely used option model is the Black and Scholes model. Although there are some shortcomings, the model is appreciated by many professional option traders and investors because of its simplicity, but also because, in many circumstances, it does generate a fair value for option prices in all kinds of markets.

The main shortcomings, of which most of them will be discussed at a later stage, are:

The model assumes a geometric brownian motion where the market might deviate from that assumption (jumps), it assumes a normal distribution of daily (logarithmic) returns of an asset or Future while quite often they have a tendency towards a distribution with high peaks around the mean and fat tails. It assumes stable volatility while the market is characterised by changing (stochastic) volatility regimes. It also assumes all strikes of the options having the same volatility; it doesn’t apply skew (adjustment of option prices)in the volatility smile/ surface and so on.

So in principle there may be a lot of caveats on the Black and Scholes model, however, because of the use of it by many market participants (with adjustments to make up for the shortcomings) in combination with its accuracy in many occasions, it may remain the basis option model for pricing options for quite some time to go.

This book is meant to explore and explain the ins and outs of the Black and Scholes model (to be precisely the Black ’76 model on Futures, minimising the impact of interest rates and leaving out dividends). It has been written for any person being active in buying or selling options, being involved in options from a business perspective or just being interested in learning the background of options pricing which is quite often seen as a black box. Although this is not an academic work, it could be worthwhile for academics to understand how options and their derivatives perform in practice rather than in theory.

The book has a very practical approach and an emphasis on the distribution of the greeks; they measure the sensitivity of the value of an option with regards to changes in parameters like the strike, underlying (Future), volatility (measure of the variation of the underlying), time to expiry or maturity and the interest rate. It further emphasises on the implications of the greeks and understanding them with regards to the impact they will/ might have on the P&L of an options portfolio. The aim is to give the reader a full understanding of the multidimensional aspects of trading options.

Measuring the sensitivity of the value of an option with regards to changes in the parameters one could discern many greeks, but the most important ones are:

Delta: the price change of an option in relation to the change of the underlying

Vega: the price change of an option in relation to volatility

Theta (time decay): the price change of an option in relation to time

Rho: the price change of an option in relation to interest rate

These greeks are called the first order greeks. Next to that there are also second order greeks, which are derivatives of the first order greeks like gamma, vanna, vomma etcetera and third order greeks, being derivatives of the second order greeks like color, speed etcetera.

The most important one of the higher order greeks is the gamma which measures the change of the delta.

When greeks are mentioned throughout the book, it usually relates to delta, vega, theta and gamma for they are the most important ones.

The book will teach how to value at the money options, its surrounding strikes and their main greeks without applying the option model. Although much is based on rules of thumbs and approximations, valuations without the model can be very accurate. It is not the main target to being able to value/ approximate option prices and their greeks from the top of the head, however being able in doing so must imply that one fully understands how pricing works and how the greeks are distributed. It will enable the reader to philosophise about and calculate how an option strategy could work out in a four dimensional way. The reader will learn about the consequences of options pricing with regards to changes in time, volatility, underlying and strike, all at the same time.

People on the verge of entering into an option strategy quite often prepare themselves checking books or the internet. Too often they find explanations on a certain strategy which are only based on the pay out of an option at time of maturity, hence a twodimensional interpretation (underlying price versus profit loss). This can be quite misleading, since there is so much to say about options during their lifetime. Something some people might already have experienced when being confronted with adverse market moves while running an option strategy with associated losses. Any change in one of the before mentioned parameters will result in a change in the value of an option. In a two dimensional approach (i.e. looking at profit loss distribution at expiry) most of the greeks are disregarded while during the lifetime of the option, they can be the ones making or breaking the strategy.

Throughout the book, any actor being active in buying or selling options, i.e. a private investor, trader, hedger, portfolio manager etcetera, will be called a trader.

Many people understand losses originated from bad investment decisions when buying options or potentially unlimited losses when being short options, however quite often they fail to see the potentially devastating effects of misinterpretation of the greeks.

For example, a trader who sold the 40 put at 1.50$ when the Future was trading at 50 (volatility at 28%, maturity 1 year), had the right view. During the lifetime of the option, the market never came below 40, the put expired worthless, and the trader consequently ended up with a profit of 1.50$.

Chart 1.1 P&L distribution of a short 40 put position at expiry

The problem the trader may have experienced however is that shortly after inception of the trade, the market came off rapidly towards the 42 level. As a result of the sharp drop in the underlying, the volatility may have jumped from 28 % to 40 %. The 40 put he sold at 1.50$ suddenly had a value of 5.50$, an unrealised loss of 4$. It would have at least made the trader nervous, but most probably he would have bought back the option because it hit his stop loss level or he was forced by his broker, bank or clearing institution to deposit more margin or even worse, being stopped out by one of these institutions (at a bad price) when not adhering to the margin call.

So an adverse market move could have caused the trader to end up with a loss while being right in his strategy/ view of the market. If he would have had anticipated on the possibilty of such a market move he might have sold less options or would have kept some cash for additional margin calls. Consequently, at expiry, he would have ended up with the 1.50$ profit. Anticipation obviously can only be applied when understanding the consequences of changing option parameters with regards to the price of an option.

A far more complex strategy with a striking difference in P&L distribution at expiry compared to the P&L distribution during its lifetime is a combination where the trader is short the 50 call once (10,000 lots) and long the 60 call twice (20,000 lots)and at the same time short the 50 put once (10,000 lots)and long the 40 put twice (20,000 lots), he received around 45,000$ when entering into the strategy. The P&L distribution of the combination trade at expiry is shown below in Chart 1.2

Chart 1.2

The combination trade will perform best when the market is at 50 (around 45,000$ profit) and will have its worst performance when the market is either at 40 or at 60 at expiry (around 55,000$ loss).

The strategy has been set up with 1 year to maturity; a lot can happen in the time between inception of the trade and its expiry. In an environment where the Future will rapidly change and where as a result of the fast move in the market the volatility might increase, the P&L distribution of the strategy could look as follows in a three dimensional way (P&L versus time to maturity versus underlying level):

Chart 1.3 Combination trade, long 20,000 40 puts and 60 calls, short 10,000 50 puts and 50 calls

Chart 1.3 shows the P&L distribution of the combination trade in relation to time. When looking at expiry, at the axis “Days to expiry” at 0, the P&L distribution is the same as the distribution depicted in the twodimensional chart 1.2. The best performance will be at 50 in the Future, resulting in a P&L of around 45,000$ and the worst case scenario is when the Future will be at 40 or at 60 when the loss will mount up to around 55,000$. However, when the maturity is 365 “Days to expiry” and the market starts moving and as a result the volatility will for instance increase, the performance will overall be positive, with the profit around the 50 level in the Future being the least but still a few thousand up, a profit of around 35,000$ when the Future will be at 60 and around 10,000$ when the Future will be around 40. These P&L numbers keep changing during the lifetime of the strategy, for instance the 35,000$ profit at 60 in the Future (at 365 days to expiry) will turn into a 55,000$ loss at expiry when the market stays at that level, hence losses in time, called the time decay or theta. Also when the trade has been set up, the value of the portfolio increases with higher levels in the Future, so there must some sort of delta active (change of value of the portfolio in relation to the change of the Future). Next to that, the P&L distribution displays a convex line between 50 and 65 at 365 days to expiry and hence it means that the delta will change as well, changes in the delta are called the gamma.

So the P&L distribution of this structure is heavily influenced by its greeks, the delta, gamma, vega and theta, hence a very dynamic distribution. Thus without understanding the greeks, this structure would not be understandable when looking at the P&L distribution from a more dimensional perspective.

It is of utmost importance that one realises that changing market conditions can make an option portfolio with a profitable outlook change into a position with almost certainty of a negative P&L or the other way around as shown in the example above. Therefore it is a prerequisite that when trading/ investing in options one understands the greeks.

This book will, in the first chapters, discuss probability distribution, volatility and put call parity

Then the main greeks, being the delta, gamma, vega and theta. The first order greeks together with the gamma (second order greek) will be the most important and thus be discussed in length. The other greeks are derived from those, they will be discussed as well however be it briefly if at all. When understanding the regular greeks one can easily filosophise about these other second and third order greeks and understand how they work.

In the introduction of a chapter on a greek, the formula of this greek will be shown as well. The intention is not to write about mathematics, its purpose is to show how parameters like underlying, volatility and time will influence that specific greek. So a mathematical equation like the one for gamma: should not bring despair. In the chapter itself it will be fully explained.

In the last chapter trading strategies will be discussed, from simple strategies towards complex structures. The main importance however is that a trader must have a view about the market, without this view it is hard to determine which strategy is appropriate to become a potential winner. An option strategy should be the result of a careful consideration of the market circumstances. How good the option strategy will perform is fully related to the trader making the right assessment on the market direction or market circumstances. A potential winning option strategy could end up disastrous when there will be an unanticipated adverse market move. Each strategy could be a winner, but at the same time a loser as well.

The terms in, at or out of the money will be mentioned throughout the book. At the money refers to an option which strike is precisely at the level where the underlying is trading. When not meant to be precisely at the money, the term “around the at the money” will be applied. Out of the money options are calls with higher strikes and puts with lower strikes compared to the at the money strike, in the money options are calls with lower strikes and puts with higher strikes compared to the at the money strike.

The options in the book are treated as European options, hence there will be no early exercise possible (exercising the right entailed by the option before maturity date) as opposed to American options. Obviously, American option prices might differ from European (in relation to dividends and the interest rate level), however discussing this falls beyond the scope of the book. When applying European style there will be no effect on option pricing with regards to dividend.

For the asset/ underlying, a Future has been chosen; it already has a future dividend pay out and the interest rate component incorporated in its value.

For reasons of simplicity and also for making a better representation of the effect of the greeks, 10,000 units has been applied as the basis volume for at the money options where each option represents the right to buy (i.e. a call) or sell (i.e. a put) one Future. The 10,000 basis volume could represent a fairly large private investor or a fairly small trader in the real world. For out of the money options, larger quantities will be applied, depending on the face value of the portfolio/ position.