Hi everyone, read lot of stuff lately on options, still lot of things remain unclear to me. 1: Concerning dynamic delta hedging, why do traders struggle to find the best way/frequency to dynamically delta hedge their position, rather than neutralize gamma and then delta once for all? 2: I read that some MM neutralize by weighted measurements their exposure to volatility across different expiries (calendars). I don't understand why they need to neutralize vega since they are selling/buying vol? 3: I'am trying on paper a set up largely inspired by Eluan book and spreadsheets and wondering where I can find an indicator or xls for the Zakamouline hedging bands. Thank you for tour help.
hi hi 1) to neutralize gamma you will probably be trading more options and these options has its only greeks which contaminates your original position (e.g. original vega, theta are affected) 2) i believe weighing by time allows comparison across expiries and across time to decide cheap and dear. And since you are using these measures to compare, you should size your trade using these measures. 3) lets say during the day you are long delta and you strongly feel that underlying is going up for whatever reasons then you should ride your long delta for a bit before hedging to capture more pnl. hedging becomes more discretionary and trader dependent. the oracles should be waking up soon to answer your questions more precisely
(1) usually, the whole point of puting on a delta-hedged positionis to enjoy the theta/gamma outright or against some other risk (e.g. calendar trades). If you can optimize the hedging, you can (hopefully), improve the expectation of the trade or, at the very least, lower the hedging costs. (2) Market makers are rarely interested in taking on primary risks (e.g. outright short or long gamma), instead they try to convert them into secondary risks by spreading. (3) Don't know. In general, do not take filthys book as a gospel, it's just a starting point and you have to develop your own strategies and tools. my 2bp
1..liquidity and price.....sometimes the best way to hedge something is not the cheapest. So you might have to make do. 2...dont forget some MM get given their positions as they are price makers not price takers. Often you simply spread risk as best you can. If you are in stocks there are also other risks such as dividends, rates etc across various series. Plus depending on how far out you go, the vega can have a big impact if its constantly going against you hence spreading it makes sense. 3...no idea
You can neutralize gamma, for instance via ratio calendars that are gamma neutral. Then you neutralize theta as well and are left with pretty pure vega exposure... Im not sure why not more people do this, it seems to give a pretty clean vol exposure. BUT I found that you have to trade very many options for very little vega, so I guess transaction costs are prohibitive, and people just prefer to deltahedge instead. Also regarding question 2, I dont think MMs take on any exposure, they are probably looking to stay neutral all around and just arb and make the spread...
Apart from delta and gamma, other greeks like vega and theta are also primary risk? What are the secondary risks for option? Spreading you mentioned means the bid/ask spread? How to convert primary risks to this? Thanks SLE,
(1) primary risks are various volatility risks take outright - i.e. theta/gamma and/or vega. Delta trading is mostly taboo for MMs. (2) various cross-greeks, term-structure risks and interplay between various primary risks. E.g. a calendar trade is a play on richness/cheapness of gamma vs vega as well as on the shape of the term structure. (3) spreading i mean you spread one risk against another, as per above. Usually, an MM is going to skew his markets a little to try to get into a specific position (e.g. long vega, short gamma).
(2) Then seems the sell side MM's trading is much complex than the buy side, lots complicated models they have to involve in. Besides, the term-structure / smile-dynamic risk also impact the risk management for the options portfolio. The link below is the smile dynamics in scenario analysis. https://helda.helsinki.fi/handle/10227/147 (3) So MM also gamble specific position, against specific risk factor. I have thought MM only earn from the Bid/Ask spread. Thanks,
Thank you guys for all these useful explanations; I have this following answer from a MM and was wondering how can he made profit/loss from IV spread while neutralizing any impact of vega on the option value? Maybe some of you will understand this better than I do: First, one need not have an equal number of contracts in each respective month to have a calendar spread "on". Second, if your net vega is actually "long" from these calendar spreads as you say, then you are not vega-neutral as the discussion is supposed to be inferring. Third, shorter term contracts do in fact tend to be more sensitive to changes in overall volatility and can be adjusted using something we call "weighted" vega, thereby giving a more accurate reflection of this observation. An example would be (using a long "horizontal" calendar) short 30 day straddles (from $40) and long 180 day straddles (from $180)...say the market moves 2% or $20 today and IV increases across the board...the short 30day vol position will be tend to be what costs you money as the uptick in realized vol will not affect the 180 day as much. Applying a weighting to these will make you carry MORE options in the back month against the shorter dated options in order to be vega neutral (according to the weighted vega and not traditional measures). Its not perfect but it will give you a better return over time. Fourth, the general level of IV itself is independent of the relationship between the months and their respective IVs. What vega neutral calendar spreads are meant to achieve (for profit) is capturing the distortions in relative value of one month to the other. A more important consideration would be if they are contango or backwardation. What has been the behavior of the underlying and/or IV lately? What is the mean IV over different time frames? Directionality of the underlying tends to have an effect on calendar spreads as well. Calendar spreads in our business (vega neutral trading) tend to be one of the most stable spreads we have, particularly when one utilizes a weighted vega approach. Depending on the "width" of the vertical spreads you speak of, they may have more risk than what you see in the calendars. I think skew tends to be more difficult for the novice and intermediate trader to deal with and understand but there are tools to help with that as well. . I wonder what relative value (in bold) he's talking about?
PS: The quote above was an answer to someone stating that a calendar cannot be vega neutral on a Linkedin discussion.