Gamma scalping.

[galvinlee888]

The way I see it, there are many different opinions on delta hedging. After a lot of reading, live market implementation, and hundreds of mistakes, I've learned just how much of an art form this style of trading really is. The topic evokes a ton of questions which seem to have different answers depending on what type of market participant you are and what your goals/risk management needs are.

To the original poster who started this topic, yes you are right that if you long an ATM straddle, delta hedging is a means to pay your theta rent over the life of the option. In fact, the concept of delta hedging is one of the pillars of option pricing. The basic Black-Scholes pricing model is based on a no-arbitrage argument: Namely that the payoff of a vanilla European option can be replicated by holding and dynamically rebalancing a portfolio of the underlying instrument and risk-free bonds/cash. Since the prices of the underlying and risk-free rate are readily available, and we know that dynamic replication will yield the terminal payoff of the option in question (hence the two must be equal under threat of arbitrage), the option price must be equal to the set-up cost of this "self-financing" hedging portfolio.

This is what Black-Scholes does. In actuality, Black-Scholes takes your inputs for underlying price, volatility, risk-free rate, expiry, and strike and calculates the total cost of a hedging portfolio, not an option. You just assume the two are equal.

The point is that is all basic theory. Among other things, Black-Scholes assumes frictionless markets, continuous hedging, constant (or time-dependent) volatility, etc. In practice, we all know that these assumptions are clearly violated or impossible to implement. The important point to remember is that Black-Scholes has proven itself to be remarkably robust even when traders hedge discretely and even use the wrong volatility input. Perhaps the best way I can think about delta neutral trading is this: If I believe vol over the next 2 weeks will be 15% and I can buy options trading at 10%, my expected profit is 5 vegas as calculated via Black-Scholes. And that's assuming I am right about vol. Of course I don't know, and I'm hedging discretely in a non-Black Scholes world. So while Black-Scholes may be right ON AVERAGE, my P&L is going to have variance. It is my goal as a trader to develop strategies in which I can place as many bets as I can with a positive expected value and do my best to control variance. If I hedge the fat tails and size my bets appropriately, I should be able to invoke the Central Limit Theorem over time and realize a positive drift rate for my portfolio.

In conclusion, yes delta hedging is useful, and not just for long straddles. But only if you have some type of thesis as to why vol is cheap/rich. If it is truly cheap, the summation of your delta hedging cashflow will exceed the premium paid for the option and you will realize a profit. If the option is a fairly valued, its a scratch. If the option is rich, your delta hedging will be insufficient and you will take a loss. But there are other important questions, such as what volatility do you hedge at? Implied vol? Actual vol? Something different? Each one will give you a different delta and therefore a different risk-profile to the hedging strategy.

There's a ton to learn on this topic. It's my preferred way of trading, but it has taken me years to begin even feeling out a strategy that I'm comfortable with and believe I can be successful with.

Always happy to discuss and hear what others have to say on this stuff.

How you overcome the commission and slippage in reality ?

 

[longthewings]

In reality, delta hedging once per day at the close is actually not that bad of a strategy. You get decent variance reduction relative to the unhedged case. Yes, there is still slippage, but that is unavoidable.

Second, while there are many more sophisticated ways to empirically analyze realized variance, for the most part I typically estimate quadratic variation using close-to-close data. In my mind, it therefore makes the most sense for me to hedge close-to-close once per day since that hedging interval aligns with the way I'm partitioning the data and making inferences about the volatility.

When I first started delta hedging, I made a lot of amateur mistakes. I tried to pick and choose local mins/max's and sort of hedged ad hoc. All this did was result in overhedging and poor results.

So these days I find I have far more success sticking to a once per day hedge at the close. My program is simplistic, yes, and I'm sure there are superior ways. But in my opinion, you still get decent variance reduction, and one trade per day is certainly manageable from a commission standpoint.

Best.

 

[galvinlee888]

In reality, delta hedging once per day at the close is actually not that bad of a strategy. You get decent variance reduction relative to the unhedged case. Yes, there is still slippage, but that is unavoidable.

Second, while there are many more sophisticated ways to empirically analyze realized variance, for the most part I typically estimate quadratic variation using close-to-close data. In my mind, it therefore makes the most sense for me to hedge close-to-close once per day since that hedging interval aligns with the way I'm partitioning the data and making inferences about the volatility.

When I first started delta hedging, I made a lot of amateur mistakes. I tried to pick and choose local mins/max's and sort of hedged ad hoc. All this did was result in overhedging and poor results.

So these days I find I have far more success sticking to a once per day hedge at the close. My program is simplistic, yes, and I'm sure there are superior ways. But in my opinion, you still get decent variance reduction, and one trade per day is certainly manageable from a commission standpoint.

Best.

Good idea, I never think about the delta hedging based on time parameter (end of the day).
Most people will do the hedging based on the price or greeks.

 

[samuel11]

Good idea, I never think about the delta hedging based on time parameter (end of the day).
Most people will do the hedging based on the price or greeks.

Could you explain more on that last comment? I’m curious about who does it.

I work on a deriv desk and most of the other desks I know hedge close-close.

One reason is that risk managers often want to see your delta at the end of the day, and unless there is a lot of intraday vol, you pick the close to re-adjust your book once a day.

Consider also path-dependent options that only reset on close...