Forums  > Trading  > Delta hedging a strangle position  
     
Page 1 of 1
Display using:  

peter.russell


Total Posts: 10
Joined: Dec 2016
 
Posted: 2016-12-16 18:36
Hi,

I have been doing shorted strangle positions for a while and I also actively delta hedge them.

I had a few experiences that when I delta hedged my strangles, I loaded up a fairly large amount of delta 1 risk when the underlying price was reaching my shorted call positions. At times, the price even range traded around the strikes of my shorted calls, causing huge amount of loss just delta hedging my options positions. Not only from transaction costs, but also mainly from the mean-reverting nature of how delta would signal me to buy high sell low with my delta 1 product.


Any suggestions on how best to delta hedge when gamma is high?


Thanks,
Pete

granchio


Total Posts: 1530
Joined: Apr 2004
 
Posted: 2016-12-16 19:34
Sounds like you want your cake and eat it...

If you sell gamma, that's what you get: you have to buy high and sell low, so you will lose money on the dynaic delta rehedging by definition.
You just hope to lose less than the premium you collected at start.

You can possibly finetune the exact details of the delta-hedging strategy, but there is no way to avoid the above simple fact.

Another way of saying it, is that being short gamma is just another asymmetric strategy: you often win small (capped maximum win is the premium), and occasionally lose big (unlimited maximum losses generally speaking).

So sizing is the key, more than fine details of delta-hedging.

"Deserve got nothing to do with it" - Clint

peter.russell


Total Posts: 10
Joined: Dec 2016
 
Posted: 2016-12-17 07:22
Thanks for your reply !

Yeah I understand it's picking up nickels in front of steamrollers...

Out of curiosity, how would banks or other buyside institutes react differently to high gamma risks ?!

I am sure on a portolfio level, the effect of a number of high gamma positions might not be noticeable, but how one trader would tackle them high gammas differently should they work at different kinds of institutes?





djfostner


Total Posts: 20
Joined: Oct 2008
 
Posted: 2016-12-19 20:28
I can't speak for recent years, but years ago I recall one particular firm in some of the smaller markets (ex soybean oil) that certainly seemed to change their hedging strategy to almost nothing when they represented a significant portion of the short gamma in the market. Certainly a dangerous game to hold the whole bag like that, but net/net it would appear that they printed a good deal of money over the years by occasionally watching all the locals fight to get off small delta hedges effectively collaring the market tighter and tighter into expiration. Although I'm sure there were times that their pin risk would have made certain traders downright queasy (probably myself included). In relation to bank vs buyside, I have limited exposure on the sell side, but drinks with gentlemen much smarter than myself who ran significant exotic books at banks years ago certainly approached the topic from a much different angle (i.e. had incentive in trying to have a degree of control on the market by defending/gunning knock values, pushing values before or during settlement windows, hedging factor risk in particular products to maximize effect on particular index contracts). No idea to what degree, or if any of this still goes on. I'd be very interested to see how some of the major banks or trading houses manage their aggregate risk exposure when all their particular desks are within their risk parameters, but the aggregate risk of the firm becomes an issue.

fomisha


Total Posts: 27
Joined: Jul 2007
 
Posted: 2016-12-20 03:34
one should take the following factors into account:
- transaction costs of hedging
- cost of risk/capital (can use utility optimization)
- predictability of the returns around a pin
- predictability of realized volatility on different horizons (mean reversion)

peter.russell


Total Posts: 10
Joined: Dec 2016
 
Posted: 2016-12-20 13:57
"pushing values before or during settlement windows, hedging factor risk in particular products to maximize effect on particular index contracts"

Thanks for your advice! Really appreciate it.

Could you kindly elaborate more on above? Did you mean rolling the options with high gamma to longer dated ones (possibly also with further away strikes) in order to smoothen the gamma profile?

I wonder how much quant it needs to be for a trader to make a decision at a bank which I apparently don't have much experience with.

(TBH I work at a prop fund that is rather less quant and am hoping to quantify most trade process eventually.) I'm glad I came across this site recently.


Volmaster


Total Posts: 7
Joined: Nov 2014
 
Posted: 2017-01-15 17:45
@peter.russell

Dynamic Hedging is probably one of the most interesting subjects in derivatives trading.
As your terminal P&L of a delta-hedged option book is merely a function of underlying spot dynamic and your gamma profile, any path (and delta hedging interval) can result in a different P&L.

i've been dedicating more than half of my trading career to researching and developing delta hedging optimization algorithms,so thought of sharing my view on that:

1. When ones sell/buy option he/she should take view on two factors : trend and vol. If you thing that market is going to be in a trend, you should hedge frequently if you are short gamma and less frequent if you are long gamma (although that observations is somewhat obvious...).

2. You view of the vol is another factor, as you should, in my opinion (and back-tests) use the vol you believe is going to be realized in B&S volatility, rather than the implied/market vol. In fact, if you believe that market is going to be mean-reverting you should actually use lower vol if you are long gamma and higher vol if you are short gamma (as strange as it may sound), as this will result in greater gamma).

3. if you wish to achieve relatively flat Gamma profile, you should consider trading 3 (or 5) strikes (depends on liquidity and transaction costs obviously), as this will give you less exposure of a specific strike. I like to split my vega/gamma exposure between the ATM and the 25D strikes (as I trade FX volatility).

4. When it comes to expiry/pin risk - I usually close the risk (or roll the risk further down the maturity curve) at least two week before the expiry, as liquidity is still somewhat decent and allows reducing transaction cost.

Just my 2c....

katastrofa


Total Posts: 357
Joined: Jul 2008
 
Posted: 2017-01-15 21:35
The most important thing you need to know to understand how banks trade derivatives is that it's not "the bank" which makes the trading decisions. It's a trader employed by the bank, who will get paid his/her bonus by the end of the year but will most probably work somewhere else in five years' time when his/her trades explode.

There is a reason why derivatives trading desks lose a lot of money every N years (5 < N < 10) and why this N is so similar to the average trader's tenure in a single position.

Your goal as a trader is not to "hedge risk", it's to kick the can down the road long enough for the bonus check to clear.

Happy trading!

sigma


Total Posts: 105
Joined: Mar 2009
 
Posted: 2017-01-16 23:57
Volmaster,

Thank you for sharing your interesting thoughts. I have been working a lot on the vol trading as well - it's a very exciting topic indeed with very little practical research available so you must do a lot of R&D work on your own.

I agree with your views. Just a couple of comments:

Your views 1 and 2 arise from the same consideration: when the market is mean-reverting in the price, then the volatility realized at wider frequencies (weekly, monthly, etc) is smaller than the volatility realized at finer frequencies (hourly, daily). As a result, when being short gamma we need to hedge at higher vols to avoid whipsawing, while being long gamma we need to hedge at smaller vols to benefit from more frequent scalping opportunities.

However, the trend is still only a secondary variable for vol trading. The primary variable is the spread between the implied and the realized vols, especially if you intend to trade in a systematic way.

Btw, I trade in options on single stocks, sector and fixed-income ETFs. My understanding and empirical investigation is that FX vols do not have much of systematic risk-premia, say measured by the spread between implied and realized ATM vols, or skew, or convexity (perhaps, the sole exception). How do you generate alpha out of trading in FX vols?

wwwjnwell


Total Posts: 2
Joined: Dec 2016
 
Posted: 2017-01-17 12:18
Great advice! Thanks a lot guys.

Since some of you I believe work on optimising delta hedging model, would you at all consider incorporating bid ask order book like execution algo in your model in order to capture intra day trends which then could possible tell the hedging model when to or not to hedge ?


Volmaster


Total Posts: 7
Joined: Nov 2014
 
Posted: 2017-01-18 06:08
@Sigma,


re your comment -

1. I agree with your point, and actually stated that when market is mean-reverting one should plug lower vol when long gamma and higher vol for short gamma. My practice is simply looking at Parkinson/Garman Klass vol compared to daily/time-based volatility to detect dependencies that might indicate mean-reversion tendency.

2. Based on my experience the realized volatility of your position is going to be extremely sensitive to the way you run the risk. the decision how frequent to hedge the delta is going to determine how much vol you are going to realize (especially when market is mean reverting).

3. First, I use a filtering algorithm to screen through the 45 G10 combination and rank them statistically, and in a way that is complimentary to my trading style. On average, I have about 4-5 currency pairs that trade at (or below) fair vol at any given point, while 4-5 that are trading well above fair vol, so I trade them in RV trade. Also, in various occasions market tends to overprice the forward-vol and skew/convexity (but to lesser extent than in RV mode).



sigma


Total Posts: 105
Joined: Mar 2009
 
Posted: 2017-01-19 23:52
Volmaster,

thank you for your detailed reply. Here are my comments

1. This is a good point. I think that the impact of the combined forces of: i) Hedging volatility, ii) position gamma, iii) price trend - is quite a difficult aspect for option trading. Still in my experience it is very hard to find a reliable quantitative indicator to tackle all three in an optimal and systematic way (most of the time is comes down to discretionary decisions). Nevertheless, the first line of defense is always to have a robust model for the forecast of the spread between implied and realized vols. It is very hard to go against the spread in a systematic way even if your delta-hedge execution is superb.

2. I agree on this point. In fact I have an old paper on this topic https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1865998. An optimal hedging frequency is a function of three variables: the expected realized volatility, the spread over implied vol, and the transaction costs. Yet, it is very hard to predict and incorporate the view on the price trend. My approach is focused on using the prediction for the realized vol.

3. This is very interesting. So you trade OTC FX options in a systematic way? What platform do you use? Does it has reasonable bid-ask spreads? I trade only in exchange traded options on the relative value basis. I do trade in FX ETFs, primarily in UUP, but I do it mostly for diversification purposes. I always find it difficult to be consistently profitable in FX options using the same models as for stocks and ETFs. For me the key challenge with FX vol is that, while the average level of changes is relatively small (average realized FX vol for G-7 must be aroung 7-10%), the realized return within a short period of time can be an order of magnitude higher. In other words, short-scale returns normalized by the volatility in FX tend to be much higher than those in equities and bonds.

Volmaster


Total Posts: 7
Joined: Nov 2014
 
Posted: 2017-01-24 02:29
Sigma,

Re point 3 - My option execution is manual, as the OTC market is bit problematic for algo execution for options, however, I execute the delta (underlying spot) automatically via multibank platforms (i clear everything through a prime broker).

Volmaster


Total Posts: 7
Joined: Nov 2014
 
Posted: 2017-01-24 02:30
Sigma,

Re point 3 - My option execution is manual, as the OTC market is bit problematic for algo execution for options, however, I execute the delta (underlying spot) automatically via multibank platforms (i clear everything through a prime broker).

wwwjnwell


Total Posts: 2
Joined: Dec 2016
 
Posted: 2017-01-24 09:30
and your auto hedging algo is a function of expected future vol, portfolio delta and gamma?

Volmaster


Total Posts: 7
Joined: Nov 2014
 
Posted: 2017-01-25 03:34
My process takes into account recent spot dynamic, expected future vol/ mean-reversion tendency, portfolio gamma profile and risk-aversion tolerance
Previous Thread :: Next Thread 
Page 1 of 1