This chapter discusses how the 'Greeks' and in particular delta and gamma are used to measure and manage the risks on a short option position. It considers these risks from a trading perspective and from the viewpoint of the seller or writer of a contract operating in the dealing room, rather than that of the end-user of the product working in a company or investing institution. Certain concepts reappear in the next chapter which investigates a number of key option strategies used by professional traders and dealers. Those who are not likely to be concerned with trading and risk management issues as they affect option portfolios may wish to move on to Chapters 17 and 18. These chapters explore convertible and exchangeable bonds and a range of structured securities assembled using derivative products.
Delta is not just a sensitivity measure, although that is an important application. It is also the number that tells an option trader how to cover or hedge the risks on an option position. The problem is that the delta of an option is not stable. It changes as the spot price moves; the extent of its instability is measured by the option gamma. This fact poses serious problems for the writers of options. If a short option position has high gamma the writer will have to consider readjusting his or her hedge at frequent intervals. The result can be very expensive indeed, as the extended case study in this chapter demonstrates.