it actually does a lot. Hint: Imagine how you would hedge your short options. Would you prefer a mean-reverting, low auto-correlation environment or prefer stronger trends. Where would you hedge, how frequently. Especially paths in any other than the most liquid stocks are heavily impacted by market maker hedging activities close to expiration. It can completely determine whether a time series exhibits auto-correlation or not. Think about it.
The problem with short gamma
- Thread starter nitro
- Start date
Did you read the post about Carr's example? I understand the idea of hedging at realized instead of implied, but I am not sure you understand that doesn't help - you are still thinking about how many deltas or gamma to do. I am talking about when and how. Should I hedge every time the underlying ticks against me?
It depends on your position and on your outlook for the underlying, what you experience as "volatility." Your definition is bullet #2 below. It doesn't address the problem of not having to deal with correctly guessing what the underlying is going to do. You are back to delta trading.
"The definition of volatility is itself volatile." - Peter Carr
Uncertain Volatility
Of the paths UUUU and UDUD, which path do you think is
more volatile?
⢠To a probabilist equating the word âvolatilityâ to quadratic
variation of returns, both paths have the same volatility.
⢠On the other hand, to a statistician who equates volatility to
the standard deviation of the terminal log price, the required
estimation of the mean implies that the reverting path UDUD
has more volatility than the trending path UUUU.
⢠On the other hand, to an ATM option writer who does not plan
to delta-hedge, the trending path UUUU has more volatility
than the reverting path UDUD. This writer equates the word
âvolatilityâ to the ATM implied to charge initially.
⢠On the other hand, to an ATM option writer who does plan
to delta-hedge, the reverting path UDUD has higher volatility
than the trending path UUUU. Again, equating the word
volatility to the initial ATM implied, this writer knows that
vega and gamma are more negative along the mean-reverting
path than the trending path. Forgetting the tree, these greeks
become relevant when one is uncertain about the magnitude
of squared returns and the possibility of crashes.
⢠Of course, an ATM option buyer disagrees with the seller on
which path is more volatile and an OTM call trader disagrees
again.
Of the paths UUUU and UDUD, which path do you think is
more volatile?
⢠To a probabilist equating the word âvolatilityâ to quadratic
variation of returns, both paths have the same volatility.
⢠On the other hand, to a statistician who equates volatility to
the standard deviation of the terminal log price, the required
estimation of the mean implies that the reverting path UDUD
has more volatility than the trending path UUUU.
⢠On the other hand, to an ATM option writer who does not plan
to delta-hedge, the trending path UUUU has more volatility
than the reverting path UDUD. This writer equates the word
âvolatilityâ to the ATM implied to charge initially.
⢠On the other hand, to an ATM option writer who does plan
to delta-hedge, the reverting path UDUD has higher volatility
than the trending path UUUU. Again, equating the word
volatility to the initial ATM implied, this writer knows that
vega and gamma are more negative along the mean-reverting
path than the trending path. Forgetting the tree, these greeks
become relevant when one is uncertain about the magnitude
of squared returns and the possibility of crashes.
⢠Of course, an ATM option buyer disagrees with the seller on
which path is more volatile and an OTM call trader disagrees
again.
i guess you actually do not understand my post. I addressed the when and how. I said "once you understand the position of market makers and how they hedge" then you understand also how and when YOU hedge. How many gamma and delta you hedge on your own position fully depends on your own models. If thats still unclear then you may wanna read a litte what Eun Sinclair has to say in his book. I think it addresses most of your questions.
An option writer who "doesn't delta hedge" isn't a special case: he's just a delta-hedger who happens to only hedge at expiration.
UUUU or other form of auto-correlation isn't a special case; it's only a factor for someone who calculates variance using monthly/yearly (rather than daily) samples. UDUD and UUUU would be identical for a delta-hedger hedging on a daily basis, of course.
After reading through the thread... seems to me your primary point is that trading costs make hedging impractical for retail option traders. I really, really disagree with that. With futures costs at ~$5 all-in per contract, how is cost an issue?
UUUU or other form of auto-correlation isn't a special case; it's only a factor for someone who calculates variance using monthly/yearly (rather than daily) samples. UDUD and UUUU would be identical for a delta-hedger hedging on a daily basis, of course.
After reading through the thread... seems to me your primary point is that trading costs make hedging impractical for retail option traders. I really, really disagree with that. With futures costs at ~$5 all-in per contract, how is cost an issue?
I don't really understand what you're trying to achieve here, nitro...
If you're trying to say that vol is unknowable and unquantifiable (i.e. an "unknown uknown" using Rumsfeld-speak), I won't disagree. However, it's an impractical attitude, as it means we should all go home now and stop trying.
A much healthier view, IMHO, is to assume that there's some sort of structure to the price and vol processes and to try to figure out how to describe it in incrementally more robust ways. That's the premise behind a large body of contemporary academic work in finance.
I am not suggesting you stop trying. That is your prerogative. I made a simple statement about short gamma, backed by theoretical and empirical evidence from Peter Carr.
Look at the example by Peter Carr as it explains what I am saying more carefully. I am saying that even defining volatility is a huge problem. It will depend on your position, and then what you experience as "high or low volatility" will depend on the underlying path.
What I am trying to say is, trading vola purely is a pipe dream unless you are a bank and have access to exotic variance or vola swaps, or perhaps hyper options. Peter's example show this beautifully.
In summary, you cannot escape movements in the underlying with vanilla options (or even simple spreads), and beginning traders should throw just about all options books in the garbage can that claim you can just trade vola statically even by putting on a spread and forgetting about it, especially from short gamma point of view in the presence of hedging. This is very dangerous misinformation.
Since the buyside basically controls the underlying path, they control the volatility they experience in their own option position. That leaves open a path to a new manipulator, "hedge funds" that make markets in options. We have transferred the manipulator from the specialist to the option MMs. I am close to believing that you should not be allowed to trade both options and the underlying as a single firm, except for hedging purposes.
i also am not purely sure what you are trying to suggest.
I personally witnessed how in my prop group index vol traders forked out millions of dollars purely trading vol and skew. I have never met any traders that were more anal about being delta hedged and never overheard more discussions about which approach they thought were most efficient than from those guys. The index options they traded were all exchange traded. I know for sure that the most exotic instrument they traded was var swaps, which actually is far from being exotic, and can be replicated very easily.
Of course did those traders adjust their hedges, nobody suggests to leave hedged positions untouched, I am not sure where you try to get to.
And the buy side...that is you ...buddy among all the other market participants, and yes, we all do directly influence the underlying path. So what?
I personally witnessed how in my prop group index vol traders forked out millions of dollars purely trading vol and skew. I have never met any traders that were more anal about being delta hedged and never overheard more discussions about which approach they thought were most efficient than from those guys. The index options they traded were all exchange traded. I know for sure that the most exotic instrument they traded was var swaps, which actually is far from being exotic, and can be replicated very easily.
Of course did those traders adjust their hedges, nobody suggests to leave hedged positions untouched, I am not sure where you try to get to.
And the buy side...that is you ...buddy among all the other market participants, and yes, we all do directly influence the underlying path. So what?
I completely disagree. Defining volatility is not a problem at all. There's a definition out there that the mkt unanimously accepts as the right one. Saying that everyone's personal experience of volatility varies is an entirely different kettle of fish. Ultimately, you (and Carr) are simply saying that investors' objective functions (i.e. ways of measuring utility) can and do differ.
I don't really understand what you're trying to say here. In general, I have stated my view on short gamma strategies many times.
From my experience in the mkt (not equities, though), the buyside doesn't control the underlying path, not in the grand scheme of things. Occasionally, they might, but those times are few and far between. I can tell you a lot of stories about BSDs that thought they were so big they could tell the mkt what to do. Most, if not all, of these characters are not in the mkt any more. So I don't buy this "manipulator" theory of yours and disagree with the restriction, as it makes no sense to me whatsoever.
Index options are a different animal. For one, many of those are pit traded, and you can see the flow coming into the pit and calibrate accordingly. Very difficult for a single firm to control the underlying as well (although in this light volume environment it may be easier than I think). This is probably your experience and it makes sense that your point of view is such. I also have experience with MMing index options (SPX). Single equity options are what I am talking about, or even index options (ETFs actually) if you don't have access to option flow, i.e., you are in a pit.
But even with that explanation, you are keying on my "complaint". READ WHAT PETER CARR SAYS AND EITHER YOU AGREE WITH IT OR NOT! Forget about what I am saying. First let's see if you agree with that or not. Then we can move to my "complaint".
But even with that explanation, you are keying on my "complaint". READ WHAT PETER CARR SAYS AND EITHER YOU AGREE WITH IT OR NOT! Forget about what I am saying. First let's see if you agree with that or not. Then we can move to my "complaint".