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I am looking for methods to select points in time when delta hedging plain vanilla European options under trading costs.

It is easy to come up with ad hoc ideas such as

  1. Time-based: for example at fixed time intervals.
  2. Price-based: hedge when the price has moved a more than a given percentage.
  3. Delta-based: hedge when the option delta has reached a given threshold.

How is the delta hedging frequency choosen in practice? Could you point out more sophisticated methods in the literature? Would Taleb's book on dynamic delta hedging be a good investment?

Edit: What I have found so far:

  • Option Pricing and Replication with Transaction Costs, Leland, Journal of Finance, 1985.
    He disscusses rehedging at fixed regular intervals.
  • Hedging of Option Portfolios and Options on Several Assets with Transaction Costs and Nonlinear Partial Differential Equations, V. Zakamouline, 2008.
    Extends Leland's approach to other options, especially path-dependent options.
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Your question is somewhat ambiguous. On the one hand you are asking how to set the rebalacing frequency of the hedging portfolion on the other hand you ask the very general question "how is delta hedging done in pratictice". Is your question primarily about "hedgint-frequency" or delta hedging in general ? – Probilitator Mar 19 '14 at 19:37
@Probilitator I have changed the wording. – user1157 Mar 20 '14 at 10:06
super - now you have a truly intersting question - thanks :) - great nick name by the way :D I changes the question title. You might want to alter it further to better reflect what you are actually asking in the question body. – Probilitator Mar 20 '14 at 10:25

2 Answers 2

First when transaction costs are involved the trader has to make a tradeoff between return and risk. Continuous rebalancing/hedging could lead to infinite transaction costs but provides (in theory) a perfect hedge. Discrete hedging enables to minimize transaticton cost but leads to hedgint errors and more risk. To find a price one must introduce an optimization criteria (e.g. a utility funtion)

As already mentioned it is hard to name "the one approach" that is done in practice. I will thus refer you to some texts to get you started on the topic. Banks etc. will develop their own methods using results from research/academia. Good methods equal good money - so people will not readily part with their secrets. Knowing the theory and the reasoning behing some of the approaches will however enable you to make your own condlusions.

Some interesting papers/results on the topic:

For a good overview I also suggest the following Phd-Thesis - e.g. check the Bibliography.

Som general remarks: A method must not be sophisticated to work well. There are different types of hedging approahes. Some traders might use algorithms other might trust their gut.

You should also be aware that the hedge itself strongly depends on the type of product and on the assumptions you made on the model/market. A hedge of a plain vanilla call will differ depending on the model (e.g. B&S vs. Heston) An American option is hedged differently than a European one. The model assumptions on the other hand depend on the type of product you want to price/hedge.

Also there is often a big gap between what is written in books and done in practice. The productive solutions are frequently a mixture of different approaches presented in different sources.

Some quant stack exchange topics that you might find interesting/relevant:

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You can formulate the problem of finding the optimal hedging frequency under transaction costs to maximize the Sharpe ratio of the delta-hedging strategy. The risk is the P&L volatility and the reward is smaller transaction costs. Analytical solutions and similar analysis can also be applied to spot- and delta-based hedging strategies.

Details in When You Hedge Discretely: Optimization of Sharpe Ratio for Delta-Hedging Strategy under Discrete Hedging and Transaction Costs

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