Continous hedging as a rachet device to lock-in profits

[ironchef]

I simply don't get why some people still are talking of MMs when the topic is hedging. They seem to have not learnt anything else regarding hedging...

botpro, I am not trying to take side, just someone new to options trying to understand dynamic hedging and your thinking. I actually enjoy your posts, don't know if you are right or wrong but you have some very interesting foods for thoughts for me.

First of all I think you are right, dynamic hedging can be done by anyone trading options, whether you are a bank, MM or a retail trader like me. Of course for me, the transaction costs for constant hedge will be prohibitive. I also assume that to first order, dynamic hedging means delta hedge and adjusting the hedge as delta changes to make the trade delta neutral?

Second, if the options are fairly priced, as one of your reference studies stated, the net P&L will be zero (ignore transaction costs) if you hedge right from the moment you sold the put options. So, you only profit (loss) if the options you sold were mispriced. In that case, hedging will lock-in the profit (loss). Normally, if the implied volatility is high compared to historical volatility, then you will likely have a lock-in profit at expiration if volatility reverted to historical value? If put options are expensive (compared to theoretical prices) as stated by all of you here, then dynamic hedge from the get go will almost ensure a lock-in profit that is "guaranteed", provided the transaction costs are less than the profit potential? However, if puts are so expensive, why buy? Who buys?

Third, let's say after selling the put, you waited and only start to hedge after the trade moves in your favor and you can lock-in but then "ratchet up", changing the hedge ratio and lock-in higher and higher profits? However, what happen if the trade moves against you after the trade was made? Do you try to lock-in a loss to prevent a potential run away loss? Do you then re-hedge when the trade moves in your favor later?

I welcome comments from all of you.

 

[Martinghoul]

1. Yes, correct. "Dynamic hedging" is commonly used to refer to delta hedging.

2. Simplistically, if, over the lifetime of the option, the volatility that you actually realized through delta hedging is lower (higher) than the implied volatility that you "sold", you're going to make (lose) money. The "expensiveness" of puts offers your delta-hedged short put position mild profits in a variety of "normal" outcomes and large losses under some relatively low-probability outcomes. Moreover, being short options (in equities, it's puts in particular) exposes you to the ultimate "unknown unknown", i.e. liquidity risk. The issue with most widely used option pricing methodologies is that they make relatively strong assumptions regarding the two points above (aka risk-neutrality and completeness). This provides an answer to the question of who and why buys. The ones who buy are people who a) really don't like to incur large losses; and/or b) who value liquidity more than the mkt does.

3. The whole ratcheting nonsense is pure noise. Like many people have stated, if you're short the puts, you're short gamma. Delta hedging a short gamma position is, by definition, a cost. My advice would be: put together a very basic Excel sheet, play around a few scenarios and get a feel for how things work.

 

[oldnemesis]

Trying to do delta hedging to reduce risk "to zero" or even close to zero will inevitably reduce your payout to AT BEST the 'risk free' rate...ie the rate on short term treasuries. So, if your interest is in investing, instead of playing with delta hedging you might as well just buy short term treasuries and clip coupons.

Just because somebody publishes a book called 'dynamic hedging' doesn't mean it has any applicability to the retail trader.

http://www.barnesandnoble.com/w/dyn...sid=Google_&sourceId=PLGoP209&k_clickid=3x209

"It presents risks from the vantage point of the option market maker and arbitrage operator."

 

[botpro]

The very first results of the simulation framework I quickly programmed confirms it:
by doing dynamic hedging one earns the credit guaranteed. But one must buy the stock fully.
Example: 10 contracts mean 10 * 100 = 1000 stocks. Throughout the lifetime of the option
one has to buy and sell some portion of the stock: initially it is about half of the stocks,
and finally at the end one will be owning all of the 1000 stocks.
The current delta value dictates how much to buy or sell at each reheadging intervall.
The net effect is: by this intelligent hedging strategy one secures the received credit, ie. there is no loss.
IMO a wonderful mechanism and strategy.
The drawback is: one should rehedge often, IMO at least once daily or once every x days, if necessary and required; the more the better.
But of course one must also add the commisions paid for all these stock buy/sell actions into the end calculation,
ie. one needs a broker with low costs, like for example IB, for applying this strategy.

Currently I only did dynamic delta hedging with a short call option.
I also read about adding more of the greeks (like gamma and some more) into the strategy to even get better results. This I'll try sometime later.

...to be continued...

 

[OptionGuru]

The very first results of the simulation framework I quickly programmed confirms it:
by doing dynamic hedging one earns the credit guaranteed. But one must buy the stock fully.
Example: 10 contracts mean 10 * 100 = 1000 stocks. Throughout the lifetime of the option
one has to buy and sell some portion of the stock: initially it is about half of the stocks,
and finally at the end one will be owning all of the 1000 stocks.
The current delta value dictates how much to buy or sell at each reheadging intervall.
The net effect is: by this intelligent hedging strategy one secures the received credit, ie. there is no loss.
IMO a wonderful mechanism and strategy.
The drawback is: one should rehedge often, IMO at least once daily or once every x days, if necessary and required; the more the better.
But of course one must also add the commisions paid for all these stock buy/sell actions into the end calculation,
ie. one needs a broker with low costs, like for example IB, for applying this strategy.

Currently I only did dynamic delta hedging with a short call option.
I also read about adding more of the greeks (like gamma and some more) into the strategy to even get better results. This I'll try sometime later.

...to be continued...

Good work botpro, it's obvious that you know what you are doing. Keep up the good work.

 

[ironchef]

1. Yes, correct. "Dynamic hedging" is commonly used to refer to delta hedging.

2. Simplistically, if, over the lifetime of the option, the volatility that you actually realized through delta hedging is lower (higher) than the implied volatility that you "sold", you're going to make (lose) money. The "expensiveness" of puts offers your delta-hedged short put position mild profits in a variety of "normal" outcomes and large losses under some relatively low-probability outcomes. Moreover, being short options (in equities, it's puts in particular) exposes you to the ultimate "unknown unknown", i.e. liquidity risk. The issue with most widely used option pricing methodologies is that they make relatively strong assumptions regarding the two points above (aka risk-neutrality and completeness). This provides an answer to the question of who and why buys. The ones who buy are people who a) really don't like to incur large losses; and/or b) who value liquidity more than the mkt does.

3. The whole ratcheting nonsense is pure noise. Like many people have stated, if you're short the puts, you're short gamma. Delta hedging a short gamma position is, by definition, a cost. My advice would be: put together a very basic Excel sheet, play around a few scenarios and get a feel for how things work.

Thank you for your reply and coaching.

 

[ironchef]

The very first results of the simulation framework I quickly programmed confirms it:
by doing dynamic hedging one earns the credit guaranteed. But one must buy the stock fully.
Example: 10 contracts mean 10 * 100 = 1000 stocks. Throughout the lifetime of the option
one has to buy and sell some portion of the stock: initially it is about half of the stocks,
and finally at the end one will be owning all of the 1000 stocks.
The current delta value dictates how much to buy or sell at each reheadging intervall.
The net effect is: by this intelligent hedging strategy one secures the received credit, ie. there is no loss.
IMO a wonderful mechanism and strategy.
The drawback is: one should rehedge often, IMO at least once daily or once every x days, if necessary and required; the more the better.
But of course one must also add the commisions paid for all these stock buy/sell actions into the end calculation,
ie. one needs a broker with low costs, like for example IB, for applying this strategy.

Currently I only did dynamic delta hedging with a short call option.
I also read about adding more of the greeks (like gamma and some more) into the strategy to even get better results. This I'll try sometime later.

...to be continued...

Interesting concepts and thank you for sharing your thoughts. I don't know if you are right but I am going to take a careful look at this.

Questions:

1. How to hedge if you are long instead of short?

2. How do you dynamically hedge against volatility?

Regards,

 

[shooter]

botpro, in your simulation you have to factor in the losses associated with the actual hedging itself. You have to view that as a 'trade' itself, not just a hedge to the short option.

For example, since you were short the call, you would buy the underlying stock as it advances up towards your short strike. Say, the stock is initially trading at 99.00. As it gets to 100.00, you buy your 1000 shares as a hedge. It whipsaws back to 99.50. Now what? If you are fully hedged (your risk profile would look similar to a short straddle at this point), you'll need to take off the shares if you are trying to profit from the short call decaying. So, you have to take the .50 cent loss on the 1000 shares.

Then, later in the day, or later in the week, stock goes to 100.50 and you find yourself needing to hedge that short call premium again. You buy 1000 shares, only to see stock trade drastically lower to 99 on a Fed governor's comments moving the whole market lower. Rinse repeat the hedging process. You'll find that the losses add up. Ultimately you would have to have a positive or neutral expectancy process for hedging, which is really just trading the underlying profitably.

Naturally your next step will be to try different hedge sizing, say, 250 shares every $1 move up in the stock as opposed to all 1000 shares at once,, but it will still come back to needing positive expectancy for trading the underlying.

 

[destriero]

The very first results of the simulation framework I quickly programmed confirms it:
by doing dynamic hedging one earns the credit guaranteed. But one must buy the stock fully.
Example: 10 contracts mean 10 * 100 = 1000 stocks. Throughout the lifetime of the option
one has to buy and sell some portion of the stock: initially it is about half of the stocks,
and finally at the end one will be owning all of the 1000 stocks.
The current delta value dictates how much to buy or sell at each reheadging intervall.
The net effect is: by this intelligent hedging strategy one secures the received credit, ie. there is no loss.
IMO a wonderful mechanism and strategy.
The drawback is: one should rehedge often, IMO at least once daily or once every x days, if necessary and required; the more the better.
But of course one must also add the commisions paid for all these stock buy/sell actions into the end calculation,
ie. one needs a broker with low costs, like for example IB, for applying this strategy.

Currently I only did dynamic delta hedging with a short call option.
I also read about adding more of the greeks (like gamma and some more) into the strategy to even get better results. This I'll try sometime later.

...to be continued...

lol wtf is this gibberish?

You're referring to trading a ten-lot in the options (short ten puts) and trading shares to hedge? 1000 stocks? Even assuming you mean shares... you would only require 500 shares per ten lot to hedge PEP if the shares were trading at $90 -- which at that point (PEP shares trading at $90) you would be in a short straddle.

 

[donnap]

OP's playing games, but for the sake of discussion.

Yes it will work...sometimes.

As with many trades there are a myriad of possible outcomes.

Scenario 1: Strat works well. You make decent money on options or hedging or both.

Scenario 2: Strat works well enough. You make some money on a difficult trade.

Scenario 3: Strat loses a little, but hedging or option side keep losses small. Again, a difficult trade.

Scenario 4: Large loss. Market moves too fast one way or the other and hedging can't keep up. Or, you are whipsawed to death by hedging operations.

Scenario 5: Disaster. Market makes a very large move on news and you are crushed by losses on one side or the other. You can't even assume that the market always going to be there.

Analysis: Could be used with discretion, but not all of the time. It is possible that it will make money the majority of the time, but potential gains are fairly capped, while the loss potential isn't. A difficult strat. Not a good idea.