Alright, I’m still at the conceptual stages with this subject--hoping to get some pragmatic input from smallish retail guys who are well-practiced with hedging away deltas to keep a vega position relatively clean. Maybe @TheBigShort can weigh in? You seem to be one of the most recent serious learners to come through the board. Calendars and diagonals can accomplish this pretty nicely.. but sometimes the vol term structure makes these unattractive to put on for what I’m trying to accomplish. So let’s say I start out selling a straddle because I want to be short vega. I figure I can either: Reduce size and just absorb the impact the eventual deltas have on my ending PnL. If there’s decent expected value on the vega thesis it should prove out over the long term, right? Since a hedge doesn’t necessarily have EV/alpha of its own, we just use it to make things a less noisy. Ratio the straddle to be short more calls than puts? Then in theory when the vega thesis itself is less favorable, at least there will be more premium from the calls that are now OTM offsetting rise in vol, and on the flip side my gains when vol does decrease healthily will offset having greater delta losses in the call side in these same scenarios assuming normal correlation between underlying and vol. Overall the account PnL would be less volatile to some degree? Find a reasonable frequency to hedge whenever I take on +/- X deltas, that will reduce delta effect on the position well enough without getting too commission or effort intensive. Pros and cons to for these options? 3) seems the more straightforward, but what does this practically look like? Over the life of the position we can buy/sell more options on the same strike, resetting to 0 deltas and keeping vega exposure within a desired range. But on a sporadic path would this run the risk of getting too messy or ending up with a position that is too sensitive toward the end? Seems simpler just to put on/take off the underlying as needed, but the cost of this is that it ties up more capital? Re-hedging at a certain frequency with underlying seems like the best option but I'm just cautious there's some caveat and it's not actually that simple. Appreciate any thoughts other traders are willing to share to give me a little more insight/direction as I get further into testing this stuff. Still a relatively new area of study for me. Thanks.
HA! thanks for the little intro, but you are really looking for some of the big boys @sle @Kevin Schmit @destriero @newwurldmn to chime in. But I will give it my best shot as I to spend a good deal of time working/improving my hedging frequencies. First thing I would say is understand your asset, for example, deltas in equities are correlated with vol. So if I am short a straddle on SPX I usually have a small lean on negative delta. Then you have to decide on your bandwidth. The smaller the bandwidth the less your final PnL will deviate from Vega(RV-IV) however you will accumulate more transaction costs. So you have a trade off. I ALWAYS hedge with the underlying, when I run out of gamma (ie the stock trended way past my short strikes) I close the whole position. There is some work I am doing with autocorrelation right now to determine if the underlying is trending or not. If it is, I will decrease my bandwidth (if I am short vol) and on the contrary let my deltas run if the asset is currently mean reverting. The last thing you have to think about is what vol should I be hedging at? Volatility changes your delta right? Hedging at implied vol will give you a very smooth PnL but it is path dependent and your final out come will very much more, on the other side if you hedge at the true RV (very unlikely) your end result will be more predictable and less path dependent. Hope this helps, let me know what you come up with as this is a very exciting topic for me.
Hey! Thanks for the in depth response. You’ve given me a few things to think about. Like closing positions entirely when the gamma is gone. That’s another set of costs to close and reset your position to keep the trade you want on. But buying back options without meaningful gamma component is better relative value for you in a sense? Having initially sold gamma? I still feel like a 5yo with a crayon compared to experienced option traders at this point—but let’s move forward re: simply hedging with the underlying. And focusing on short gamma for now. Let’s take a short Nov 16 straddle at 271.5 strike (Friday’s close). In lieu of having experience my first thought would be trying to bound deltas within +/- 50 for the life of the position? That should give room for just under a 3% move before having to adjust? I can suffer some variance as long as I have a positive PnL slope, but want to find a good balance. And if I do trade options it wouldn’t be a full-time effort to begin with so my availability isn’t continuous. In the broader sense I need to weigh the practical difficulties / costs of hedging vs. the actual utility having cleaner trades is. If reducing the risk allows trading higher size of the actual +EV positions per allotted capital, that will be a net gain. But if it’s more cumbersome than useful I would then reduce frequency or just reduce size to compensate. I’ll keep posting about this little exercise though.
Yup, fixed delta limit works. If you treat the delta limit as a hysteresis band, it works even better (i.e. hedge to the limit, not to flat).
Wow, that is an interesting concept! I wouldn’t have thought of that myself but I think this is my favorite one yet. If I’m understanding correctly I’d more or less watch very closely when it’s right at one of my bounds, then hedge something small like 10 deltas of UL at a time until the position deltas starts to recede from the limit. Thanks for the insight.
You don't even need to watch it closely, just check it sometimes (preferably more frequent than expiration of the option). Let's say you have a delta limit of 25 delta and assume that you are observing your deltas with some periodicity (does not matter if it's regular or random). You look at your position and your delta is 35 - you only trade 10 units to bring you back to the limit. This approach doesn't really change the expectation of the trade, but this way you reduce losses from being whipsawed and from bleeding the transaction costs.
fixed delta limit is definitely the least good. even under blacksholes the extreme is about twice as far as where it ends up and you are deliberately picking these out if u do fixed delta bounds. im not saying this is a trivial issue at all.
weighting your thing at inception is also not great because anytime you are worried about vega dspot on one side of the trade the side with 'the more frequent small moves' will mean the delta loses are way too costly to compensate the improved var which as you say you are trying to get as cheaply as possible
with a straddle i recommend doing nothing coz the risk reversal is helping you on the vega problems when it goes down u are only short topside, however they are generally very fair from what i can see in terms of any like black sholes delta based replication argument