Hi All, I am getting confuse about the concept of delta hedging (or dynamic hedging) of options. When written a call, to maintain the delta, i need to “buy high, sell low” the stocks. Then how about written a put, buy a call and buy a put? Is it whenever u write an option (call or put), u need to follow the “buy high, sell low” scheme; and when u buy an option (call or put), u need to follow another scheme “buy low, sell high”? Would anyone help me in explaining these concepts. Thanks a lot. Cheers, Victor
when you sell calls, you buy the stock (# of stock to buy = delta * # of calls sold) when you buy calls, you short the stock (# of stock to short = delta * # of calls sold) when you sell puts, you short the stock (# of stock to short = delta * # of puts sold) when you buy puts, you buy the stock (# of stock to buy = delta * # of puts bought) For example, lets say delta for a particular call option is 0.8; if you sell 100 call contracts (i.e., 100 * 100 = 10,000 options), to hedge your position you will need to buy 0.8 * 10,000 = 8,000 shares of stock
Hi volkovv, Thx for your reply. I would like to ask, So when i buy calls, i need to short the stock. Then should I use the “Buy low, sell high” or “Buy high, sell low” approach? I am confused by when to use the “Buy low, sell high” or “buy high, sell low” approach in hedging options. Thanks a lot. Cheers
you will not have a choice - it will depend on what your main underlying position is that you are trying to delta hedge. in your head, you must first clearly id the main position, and the overlaid hedging instrument/position. if your main position is long calls, then yes, you can use x units of short stock per 1 unit of long calls as the hedging instrument. x = the option delta. since you are long a call, you are insured, so your delta hedge will generate positive returns (the option gamma is positive - in your favor - protects you when hedge becomes unbalanced, giving you a chance to rebalance while also making a positive return). this is what you are calling ‘buy low sell high’ i think. if you were short an option, the gamma is negative, so your rebalancing returns are negative. this is what you are calling ‘buy high, sell low’ i think. if you don’t want the negative gamma, you must also gamma hedge on top of the delta hedge.
victorlung Wrote: ------------------------------------------------------- > Is it > whenever u write an option (call or put), u need > to follow the “buy high, sell low” scheme; and > when u buy an option (call or put), u need to > follow another scheme “buy low, sell high”? > basically, yes. many people call it negative / positive gamma instead.
Victor, get rid of that “buy low/sell high” terminology. Doesn’t really make a lot of sense for options although I understand what you’re saying since I work in the industry. And I won’t explain the hedging part since volkovv already answered that part. It’s good to understand why, but typically when you are trading, your deltas will be automatically calculated for you. So if you’re short deltas, you need to buy the amount of deltas you are short to be perfectly hedged. And if you’re long deltas, you need to sell the amount of deltas you are long to be perfectly hedged. REMEMBER, calls are puts and puts are calls. When you buy options, you are long gamma, and you want the stock to move like crazy so you can scalp your gamma. You can also make money from an increase in volatility in your long options and you will lose through a decrease. When you sell options, you are short gamma, and you want the stock to stay still (not move at all). The more it moves, the more you have to negatively scalp your gamma. You lose money from an increase in volatility in your short options and you will make money through a decrease in volatility. You mentioned the term “dynamic hedging.” FYI, this can only be truly achieved by building a program that automatically sends out stock orders to continuously hedge your deltas throughout the day. And you only want to use dynamic hedging when you are long gamma so when you buy options. You do not want to use this strategy when you are short gamma so when you sell options. If you have any more questions, feel free to ask.
Hydro, I understand that it’s better to be long gamma than short gamma because unpredictable stuff tends to result in wide moves that mess up a nice delta hedge. But my understanding was that delta hedging was basically used for option sellers, so that they control the risk of having to make very large payouts if the underlying moves far. If you are a buyer of options, why would one need to use dynamic hedging? You’ve paid up a premium that is basically your maximum loss, and anything else is gravy that one wouldn’t want to hedge away, yes? I mean, dynamic hedging doesn’t help you hedge anything else, like vegas and thetas, does it?
victorlung, Pretend XYZ stock is trading at 100 and you have a 100 strike price on options, so the call and put delta would both be approx 50. The inital hedge if you buy 1 call would be to sell 50 shares; if you buy one put the initial hedge would be to buy 50 shares. A week later, say the stock goes up to 110. Then the delta on the call would increase (say to 60) as it moved further in the money and the put delta would decrease (to 40). To maintain the delta neutral position on the call, you need to sell stock (in your words “buy low, sell high” - as you can see that you sell stock at higher prices as the stock moves in your favor on the call. For the put buyer, to maintain his delta neutral position when the stock is at 110, he’ll need to sell 10 shares (or buy low, sell high"). The opposite in the scenario is true for the seller of the call and put. bchadwick, All options mkt makers delta hedge their position. This is to lock-in their theoretical edge they got from buying options. For example, a mkt quote may be 7.50 - 8.50 (spreads are a lot tighter than this now) and the mkt maker may have the option worth 8.00. If he can buy it for 7.50 and maintains a delta hedged position, then he’ll make a theoretical profit of 0.50 at expiration.
bchadwick Wrote: ------------------------------------------------------- > Hydro, I understand that it’s better to be long > gamma than short gamma because unpredictable stuff > tends to result in wide moves that mess up a nice > delta hedge. > > But my understanding was that delta hedging was > basically used for option sellers, so that they > control the risk of having to make very large > payouts if the underlying moves far. > > If you are a buyer of options, why would one need > to use dynamic hedging? You’ve paid up a premium > that is basically your maximum loss, and anything > else is gravy that one wouldn’t want to hedge > away, yes? I mean, dynamic hedging doesn’t help > you hedge anything else, like vegas and thetas, > does it? Bchad, I’m not advocating “dynamic hedging.” I was just providing clarification on the term since the OP brought it up. I delta hedge all my positions (long and short), once late in the trading day. That way you can profit from extreme moves in your long gamma positions.
bchadwick Wrote: ------------------------------------------------------- > Hydro, I understand that it’s better to be long > gamma than short gamma because unpredictable stuff > tends to result in wide moves that mess up a nice > delta hedge. > > But my understanding was that delta hedging was > basically used for option sellers, so that they > control the risk of having to make very large > payouts if the underlying moves far. > > If you are a buyer of options, why would one need > to use dynamic hedging? You’ve paid up a premium > that is basically your maximum loss, and anything > else is gravy that one wouldn’t want to hedge > away, yes? I mean, dynamic hedging doesn’t help > you hedge anything else, like vegas and thetas, > does it? Also, think of it this way. When you buy options, you’re paying a premium. Why would anyone pay a premium for something? Well basically, to have the right to scalp gamma. Everytime stock moves and you hedge, you’re making money. The more it moves, the more you make. And theoretically, you will also make money if volatility increases. Generally the vol increase is why traders are putting on the position and the stock move is the 2nd part unless its an earnings play and traders are banking on a big stock move to overcome the eventual drop in vol.
this helps; I guess it makes a lot of sense if you are a market maker. If you are just using options to obtain some kind of structured exposure to an asset or limit losses, it seems like an awful lot of work and, more importantly, a lot of transaction costs.
bchadwick Wrote: ------------------------------------------------------- > this helps; I guess it makes a lot of sense if you > are a market maker. If you are just using options > to obtain some kind of structured exposure to an > asset or limit losses, it seems like an awful lot > of work and, more importantly, a lot of > transaction costs. Yes if you’re using options to help structure a deal, then the daily delta hedging really isn’t necessary. I’m talking strictly from a vol trading perspective.