'Let Gamma run' or Delta hedging

When I used work on the exchange floor I used to watch the then timber hill floor trader
Delta hedge his position in the futures. I knew that he & most of the option MM trading this way were consistently profitable. That was back in 97'. Also, knew of a fellow that traded this way in spot fx options on a bank desk & make a absolute fortune.Also around same time. Lots of edges have gone flat & mkts have adjusted since then.
A few things if possible you gentlemen could confirm of late for me that I gather from this post & others.

1) Its still a viable, consistent strategy
2) Could pull this off with an IB acct & their commission structure.
Both of course instrument/product dependent.

Just idle thoughts.

Thanks for sharing.

 

My profits aren't as big as the one who repeatedly shorts straddle [till the market wipes out him with an enormous opening lap (for example, see what happened with NFLX few weeks ago: -36% on opening)] and of course they are not as big as the one who guesses the right direction and his long Gamma position comes ITM... I just look for the volatility term structure mean reversion to earn some points of IV hedging the Delta in the meantime. In few words: small/medium profits according to other traders whose profits I have seen. But this is my way

I care as much as possible to correctly calculate the total Vega, because on different maturities you simply can't sum them but you have to weight them. I usually:
- weight the Vega of each option according to its time to maturity;
- modify the number of options bought/sold in order to have a negative or positive time-weighted Vega (according to my volatility view);
- adjust the Delta to be equal to zero as last move by selling or buying the underlying.

Thank you very much.

 

I second this recommendation... Both books by Sinclair are very useful.

 

Ok, I've read the paper. It's very interesting. I would write here some consideration without quantitative notes, in order everyone could express his ideas.

[To people who did not read it] The paper focuses on the following topic: let you can correctly estimate the future volatility better than the market (the market uses the implied volatility to achieve this goal). So, what do you have to do? You have to long or short option and then hedge the Delta.

To hedge the Delta you should calculate it, and the formula needs the volatility: which volatility should you use? The implied volatility or the "correct" actual volatility you estimated?

Wilmott and Ahmad give the answer under some assumptions:

--- Hedging with actual volatility ---

Pros: The main advantage of hedging with actual volatility is that you know exactly what profit you will get at expiration. So in a classical risk/reward sense this seems to be the best choice, given that the expected profit can often be insensitive to which volatility you choose to hedge with whereas the standard deviation is always going to be positive away from hedging with actual volatility.

Cons: The P&L fluctuations during the life of the option can be daunting, and so less appealing from a ‘local’ as opposed to ‘global’ risk management perspective. Also, you are unlikely to be totally confident in your volatility forecast, the number you are putting into your delta formula. However, you can interpret the previous two figures in terms of what happens if you intend to hedge with actual but don’t quite get it right. You can see from those that you do have quite a lot of leeway before you risk losing money.

--- Hedging with implied volatility ---

Pros: There are three main advantages to hedging with implied volatility. The first is that there are no local fluctuations in P&L, you are continually making a profit. The second advantage is that you only need to be on the right side of the trade to profit. Buy when actual is going to be higher than implied and sell if lower. Finally, the number that goes into the delta is implied volatility, and therefore easy to observe.

Cons: You don’t know how much money you will make, only that it is positive.

 

So my opinion is that a retail trader, being focused on the mark-to-market because of the margin call risk, should use the Delta calculated with the implied volatility.

Conversely, a quantitative volatility fund which is not focused on the mark-to-market issue but which has a rigorous profit target should choose the first approach.

 

I have yet to see a fund that's not focused on the mark-to-mkt .

 

Ok, that was just my guess

 

Theoretically it doesn't matter what vol you use to delta hedge. Your expected pnl is the same, but the variance of that pnl is not.

 

Huh? Wow, that was 100% wrong. Hey dude, pick up a copy of Natenburg over the weekend. You need a refresher course.

 

Well no, as the hedge ratio is a function of the vanna sensitivity of the position and any point in time (Dvega/Dspot), among others.