The best options strategies

[botpro]

Apparently you are talking about buying for long options positions.

Can you carry out any hedging for long options?

Yes, one can. By this process one gets back the debit paid for the long option.
In the end both shorting options and going long options give the same payout (for simplicity assuming strike = spot, ie. ATM).
In the first case one gets the payout immediately as credit,
in the second case one has to pay for the option, but at expiration gets it back.
Of course only when correctly hedged, ie. if dynamic delta hedging was done...

Of course in both cases one can close the position also early if one makes more profit% when both yields are annualized to make both comparable to each other...
For example 7% in 3 months is better than 10% in 6 months...

But I would say, hedging makes sense mainly with relatively big positions, like $100k and more stock value (= strike * contracts * 100).

 

[viktor_k67]

Hmm. you with your short put can very well lose more than the $20k, especially if QQQ is below your strike at expiration...

In theory yes. On practice no. When it comes close to $20K, your broker will send you margin call and close you position. You cannot lose more than you alocated.

In practice, even you have $100K on your account and you alocate $20K for unkovered options, broker allows to lock on $20K and you will receive marging call when it come close to lose $20K not $100K

basicaly, with uncovered options, potential proffit is much smaller and you cannot more that alocated.

 

[botpro]

In theory yes. On practice no. When it comes close to $20K, your broker will send you margin call and close you position. You cannot lose more than you alocated.

In practice, even you have $100K on your account and you alocate $20K for unkovered options, broker allows to lock on $20K and you will receive marging call when it come close to lose $20K not $100K

basicaly, with uncovered options, potential proffit is much smaller and you cannot more that alocated.

This might depend on the broker...

 

[longthewings]

Yes, one can. By this process one gets back the debit paid for the long option.
In the end both shorting options and going long options give the same payout (for simplicity assuming strike = spot, ie. ATM).
In the first case one gets the payout immediately as credit,
in the second case one has to pay for the option, but at expiration gets it back.
Of course only when correctly hedged, ie. if dynamic delta hedging was done...

Of course in both cases one can close the position also early if one makes more profit% when both yields are annualized to make both comparable to each other...
For example 7% in 3 months is better than 10% in 6 months...

But I would say, hedging makes sense mainly with relatively big positions, like $100k and more stock value (= strike * contracts * 100).

Dynamic delta hedging MIGHT reduce the variance of your P&L, depending on what you are trading. How do you even know if you're calculating your deltas correctly? What vol do you use to even calculate it? What confidence do you have that your vol input is correct?

Then again, in many ways hedging can actually increase your risks. Any dynamically hedged option becomes path dependent. If you get the "nasty path," you can lose a hell of a lot more than just the premium you paid to buy an option. What are you hedging with? Hard deltas (stock/futures)? Or other options? Each will pose different risk management situations.

If you're trading skewed markets (I believe you mentioned QQQ), there's even more to the story. Skews (both log-moneyness and time), stochastic vol, jumps, etc. Despite your earlier thread, you cannot continuously hedge. By definition, each tick of the market is a DISCRETE increment. A "continuous tick" is infinitely small in size and occurs in an infinitely small partition of time -- i.e. it is not observable in the real world and therefore impossible to make hedging decisions based on it. Continuous time finance theory is applicable in PRICING only....NOT hedging. Some people have recommended you read Dynamic Hedging. Well....one of the biggest themes of that book is that what works and applies for pricing (continuous time) DOES NOT work for hedging in the real market, and that thinking in discrete terms and "tricking" the continuous-time models (i.e. Black-Scholes) is the name of the game when it comes to hedging.

Moreover, delta hedging alone is not a great strategy in most markets. It might work here, and might fail miserably there. Options (and especially books of options) are exposed to higher moments of the distribution that can exert powerful effects on a portfolio. Ok so you've hedged delta (most likely incorrectly since you don't even know the correct vol to calculate your hedge ratio).....what about gamma? Vega? dDelta/dVol? dGamma/dSpot? How do you manage all of your higher order exposures while still pricing and maintaining an expected profit in the face of uncertain parameters, stochastic variables, incorrect models, transaction costs, slippage, etc.?

It's a tall order to say the least. Your ideas are not novel. And as someone who is still learning more about this stuff every day, let me save you some time and money. Delta hedging is not a panacea. Is it useful? Absolutely. But if that's all you're talking about (and from your recent postings it is), then you have only begun to scratch the surface and have a LONG way to go. If it was as easy as you think, everybody would do it.

 

[OddTrader]

Then again, in many ways hedging can actually increase your risks.

... ...

It's a tall order to say the least. Your ideas are not novel. And as someone who is still learning more about this stuff every day, let me save you some time and money. Delta hedging is not a panacea. Is it useful? Absolutely. But if that's all you're talking about (and from your recent postings it is), then you have only begun to scratch the surface and have a LONG way to go. If it was as easy as you think, everybody would do it.

Very good points indeed!

I found the discussion on static and dynamic hedging from the first book below quite interesting. (Don't have the second book yet.)

 

[ironchef]

Yes, one can. By this process one gets back the debit paid for the long option.
In the end both shorting options and going long options give the same payout (for simplicity assuming strike = spot, ie. ATM).
In the first case one gets the payout immediately as credit,
in the second case one has to pay for the option, but at expiration gets it back.
Of course only when correctly hedged, ie. if dynamic delta hedging was done...

Of course in both cases one can close the position also early if one makes more profit% when both yields are annualized to make both comparable to each other...
For example 7% in 3 months is better than 10% in 6 months...

But I would say, hedging makes sense mainly with relatively big positions, like $100k and more stock value (= strike * contracts * 100).

I still don't understand your logic how dynamic hedge can improve the profit of the position.

Let's say you are short 1 contract of put ATM. Let's say the underlying is @$100. For naked put sale, delta is + (same as long call), ATM put delta is ~ +0.5. To maintain delta neutral, you sell ~ 50 shares of the underlying. A short time later, the underlying goes up to say $110, the delta of the short put is now OTM so delta is <0.5 say ~ 0.4 meaning you now have to buy 10 shares back @ $110 to maintain delta neutral. Next, a short time later, the underlying goes down to $90, your short put is now ITM and the delta is > 0.5, say ~ 0.6 now you have to sell 20 shares @ $90 to keep delta neutral. Let's say the stock goes back to $100 and stay there until expiry. I now have to buy 10 shares @ $100 to get back to delta neutral. At the end at expiry, I buy back the 50 shares @ $100. The numbers are made up but the logic stays the same?

The net effect is I lose $100 buying the 10 shares at $110 and selling them at $100; lose $100 buying 10 @ $100 and selling 10 @ $90.. In effect you are buying high and selling low, and lose money by maintaining delta neutral and dynamically hedged, not to mention you also lose due to friction and transaction costs. This is compared to selling put without dynamical hedging.

In the case of short naked put, with dynamic hedge, you always buy high and sell low so the net effect is you always lose money when you hedge this way? What am I missing? Perhaps you don't delta neutral hedge? In that case can you share with us how you correctly hedged?

If my logic is wrong, please someone point it out to me. As someone new to this game, all I want is to learn how best to trade options.

Thanks.

 

[botpro]

Hi ironchef,
very good example.

It's not about improving the profit, it is rather about keeping the credit (or earning (back) the premium) fully or nearly fully, ie. earning the time value, with approx. zero risk.

But then also think about what all the countless research papers and books about hedging are telling.
They can't all be wrong. Here's even a proof of hedging given:
"Pricing and Hedging under the Black-Merton-Scholes Model" by Liuren Wu
http://faculty.baruch.cuny.edu/lwu/9797/EMSFLec5BSmodel.pdf
Therein are such statements like these:
- "The portfolio is riskless (under this thin slice of time interval) and must earn the riskfree rate."
- "Since we can hedge perfectly, we do not need to worry about risk premium and expected return.[...]"

The art is to hedge in shorter intervalls; ie. one has to find the optimal hedging intervall.
I think the intervalls should be dynamic, depending on the delta and possibly also other factors...

I'm sure some experts here can give you a better answer than me as I'm at the moment short of time.

 

[OddTrader]

I still don't understand your logic how dynamic hedge can improve the profit of the position.

... ...

If my logic is wrong, please someone point it out to me. As someone new to this game, all I want is to learn how best to trade options.

Thanks.

It's our pleasure to learn from the great trading philosopher and research professor on ET!

 

[botpro]

Hi ironchef,
very good example.

It's not about improving the profit, it is rather about keeping the credit (or earning (back) the premium) fully or nearly fully, ie. earning the time value, with approx. zero risk.

But then also think about what all the countless research papers and books about hedging are telling.
They can't all be wrong. Here's even a proof of hedging given:
"Pricing and Hedging under the Black-Merton-Scholes Model" by Liuren Wu
http://faculty.baruch.cuny.edu/lwu/9797/EMSFLec5BSmodel.pdf
Therein are such statements like these:
- "The portfolio is riskless (under this thin slice of time interval) and must earn the riskfree rate."
- "Since we can hedge perfectly, we do not need to worry about risk premium and expected return.[...]"

The art is to hedge in shorter intervalls; ie. one has to find the optimal hedging intervall.
I think the intervalls should be dynamic, depending on the delta and possibly also other factors...

I'm sure some experts here can give you a better answer than me as I'm at the moment short of time.

Found also this statement in the above paper:
- "Rebalanced daily, 95% of the risk can be removed over the whole sample period."
Ie. if one can rebalance even more than once a day then nearly all of the risk can be removed, meaning approx. zero risk.

 

[ironchef]

But then also think about what all the countless research papers and books about hedging are telling.
They can't all be wrong. Here's even a proof of hedging given:
"Pricing and Hedging under the Black-Merton-Scholes Model" by Liuren Wu
http://faculty.baruch.cuny.edu/lwu/9797/EMSFLec5BSmodel.pdf
Therein are such statements like these:
- "The portfolio is riskless (under this thin slice of time interval) and must earn the riskfree rate."
- "Since we can hedge perfectly, we do not need to worry about risk premium and expected return.[...]"

Exactly, if you do continuous hedging, you ended up getting risk free rate of return, e.g., 3 month T-bill rate if the duration of the option is 3 months, and not the outsize return we expect from options trading.

From what I read, I thought the concept of option pricing was based on discounting from risk free rate, volatility, and most important, from the non arbitrage principle, so a risk free hedging will have to return a risk free rate or someone can arbitrage and get a risk free profit greater than the risk free rate?