What is the max loss on a long straddle if you long/short stock to scalp gammas

[Victor123]

If I buy an ATM straddle and on a daily basis, I scalp the gammas to remain delta neutral, then is it fair to say that the total max loss on the position is still limited to the amount paid for the straddle?

Somehow in my mind, the concept of adding short stock to a position is analogous with 'unlimited risk', hence I am asking the question.

 

[rmorse]

Not if you lose money scalping or incur a lot of commissions or exchange fees.

 

[Victor123]

Not if you lose money scalping or incur a lot of commissions or exchange fees.

Yes I understand. But there is still no chance of a catastrophic (unlimited loss) that you usually associate with a naked short position. Correct?

 

[rmorse]

Correct.

 

[Victor123]

Not if you lose money scalping or incur a lot of commissions or exchange fees.

Just to elaborate, you can lose money scalping when the underlying develops a trend instead of bouncing around,correct?

 

[rmorse]

You can lose money scalping if you don't do it properly. If you over trade rather than trade the position when you reach certain delta levels.

 

[Victor123]

You can lose money scalping if you don't do it properly. If you over trade rather than trade the position when you reach certain delta levels.

Got it, thanks. Can you provide a guideline for choosing a proper delta level to maintain? I always try to maintain 0 delta, so I guess that leads to overhedging? How can I determine a proper delta level at which to rehedge?

 

[rmorse]

Got it, thanks. Can you provide a guideline for choosing a proper delta level to maintain? I always try to maintain 0 delta, so I guess that leads to overhedging? How can I determine a proper delta level at which to rehedge?

Sorry I can't do that. There are too many things to consider including your risk tolerance, how volatile the stock is ,how much time to expiration etc.

 

[longthewings]

If I buy an ATM straddle and on a daily basis, I scalp the gammas to remain delta neutral, then is it fair to say that the total max loss on the position is still limited to the amount paid for the straddle?

Somehow in my mind, the concept of adding short stock to a position is analogous with 'unlimited risk', hence I am asking the question.

The reason it is not unlimited risk is because your max/min net delta is capped. Say you are long one straddle. Then in the right tail, your delta is 1. In the left tail, your delta is -1. So your delta hedge will always be somewhere between [-1,1], and if it is at either end of the interval, it is perfectly offset by one of the options, therefore limiting your risk.

Scalping can be tricky. Hedging at discrete intervals induces path dependency which means that if you buy the straddle at 20% IV, realized vol turns out to be 30%, but you hedge discretely, you could still somehow take a loss depending on the random price path.

Always make sure you're performing some type of analysis of the vol as a sanity check. Measure the IV of the options you're buying and compare it to the range of historical vol. You should at least be able to form a solid thesis as to why the vol is cheap and what your potential upside/downside is from buying the straddle and delta hedging to expiration.

To get an idea of your downside risk, find recent lows in historical vol and compute your option prices with the low-vol figure as your implied volatility.

Hope this helps.

 

[newwurldmn]

Got it, thanks. Can you provide a guideline for choosing a proper delta level to maintain? I always try to maintain 0 delta, so I guess that leads to overhedging? How can I determine a proper delta level at which to rehedge?

This is the art of volatility trading. A lot of proprietary research is devoted to this.

If you are long a straddle - if you hedge frequently, you can more closely mimic the realized vol of an underlying but you incur more transaction costs.

If you hedge less frequently, you are going to deviate more from your theoretical (implied vol - realized vol) pnl but you incur fewer transaction costs.

Further if you can develop a view on delta, you can overlay that on your strategy by hedging occasionally - however, that could be viewed as a separate trade all together, which is the path dependency that longthewings is referring to. If you rally 5% in the underlying and don't hedge, you will make a lot more money if the stock continues to rally 5% or will lose your gamma pnl if the stock falls 5%. If you hedge you will make a little bit of money if the stock goes in either direction.