Imo, a perfect hedge is essentially an exact replication of the option using the underlying at that moment in time. Hedging in the traditional sense is used to isolate the spread between realized vol and implied vol. So you can profit from a favorable vol thesis with less interference from directional PnL.
That's actually a piece that I've been poking at and trying to understand. If I start with a high-IV underlying and delta-hedge my option (say, a short put) right from the start, then theoretically, theta and vol collapse should just work in my favor - and if I exit the trade before gamma goes into meaningful territory, then... that sounds suspiciously like a winning scenario. But that's where I'm stuck: without a way to model it, I don't know where the problems lie. And just throwing money at the market without having a better clue than that has not proven particularly useful ("P&L goes up, P&L goes down; you can't explain that!")
In practice, continuous hedging is not possible, and to solve for the right hedge amount you need vol, which is unknown. So we can set frequency and estimated vol that are “good enough” for our purposes.
The piece I'm missing here is pricing things in vol. I've seen a few people mention it here, and it seems like it would be super-useful for normalizing - but I can't find any resources on how to do it. Any suggestions?
(I should mention that my last practical experience with statistics goes back to the Paleozoic Era or so. Don't laugh; hitching up those trilobites for the ride to class was a total bitch. Even then, I wasn't as lucky as NN Taleb, who realized that it was important and exciting - you could make money with it! - so I basically slogged through it then, and forgot it immediately after. It's on the schedule, but... dammit, the practical end of doing options is already filling this old brain to capacity for the moment.
Math, algebra, fair amount of calculus, even the practical/implementation aspects of data science - those, I've got. Theoretical underpinnings, all gone.
)
Hedging does not repair losing trades or turn losses into gains.
...Thanks. Seriously, I needed to read that. There seems to have been a "wish and hope" fantasy running around in my head, even though I pretty much knew better.
If you are short an option and vol rises, you just had a -EV event. The particular path within the spectrum of variance that was realized can still produce positive PnL, so this obfuscation causes a lot of problems for people in the long run. I.e. if you sell a 5 delta put, spot realizes greater vol than you sold but doesn’t make it all the way to the strike before expiry: terminal PnL is positive, but that scenario repeated a large number of times with different price paths will result in net losses.
Can you explain
why there's a greater negative expectancy for these? I'd love to understand it. Reason I'm asking: I have a friend who puts on 0-day low-delta ICs all the time, and he's generally pretty successful with them (he sets stops inside the shorts that are about equal to max profit, and adjusts them as expiration moves closer.) I've been trying to figure out what the flaw is in this, and nothing beyond probability of touch - which doesn't seem to come into play very often in his setups - comes to mind.
And you’ve also got to be asking yourself what is fair compensation for having extremely high covariance with the worst systemic shocks. Marginally positive PnL isn’t good enough.
I don't understand why there's greater correlation between systemic shock/risk and low-delta options. It's a product, right?... again, I'm about at the limit of my scope, but that's what I recall.
Regardless, things might be clearer if you define your thesis more precisely. If you want to be long a stock, trade the underlying. If you think for a specific time period, options are mis-pricing future realized vol, then trade the options. Selling puts becaue IV is high and you wouldn’t mind owning spot is too conflated to get good feedback from the market and actually learn from the outcomes.
Well... then I have a really serious fundamental problem. I don't have a directional thesis on the movement of anything - except maybe general positive drift in SPX and related. Everything I've seen just keeps reinforcing this: chart-reading/TA, FA, whatever kind of voodoo I've heard of, none of them seem to produce a meaningful correlation to realized movement. IOW, nobody seems to have the slightest fucking clue about what's going to move where - and the "gurus" who sell their magic potions seem the least clued in.
The only two approaches that seem to work are:
1) Brute force via risk management: make 50/50 bets and set your stops and limits at 1:3 or more, and over time, you'll get lucky. Maybe get some improvement from playing the limits, like "price generally doesn't move more than 2SD in a day".
2) Have a thesis on vol, which seems to have some poorly-explored corners - although there's a bunch of quant shops banging away on that. Since vol
is mean-reverting, and
does generally move in a more-or-less defined range during a more-or-less defined percentage of the time, this seems more promising to me (whereas sticking darts in a red-and-green magical chart does not.)
If I'm misconstruing something,
please enlighten me. Otherwise, I don't have the slightest clue of where to start getting a clue.
I'm pretty much certain that there are inefficiencies in any system with this many moving parts... don't want to pretend that I know more than I do, but just from what I've seen so far, I think I can learn to do this well.