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I am analyzing portfolio protection by replication of a put.

Having my portfolio with value $V$ I could buy put giving me the payoff $P$ resulting in a call like pay-off scenario $C=V+P$. Say, I don't want to buy the put but replicate it by taking positions according to the Delta.

I know there are problems involved:

  • Black-Scholes is wrong, we have jumps, changing volatility and other things
  • however if we do it nevertheless then we have to trade frequently (reestimate volatility, take positions with the new Delta, ...)

If I do this often and correctly. What about the Gamma of the put. I am a bit confused. Do I have to address Gamma? Gamma punishes me if I do not trade frequent enough - I know. But how does Gamma influence the success of my procedure. Say vol is constant and the stock price follows GBM and the only decision is how often I trade. How does Gamma harm me? Can I do something else besides buying other options to hedge Gamma risk or can I do something using the underlying (I assume not)?

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If you could hedge continuously with zero transaction costs, the gamma would be irrelevant: you would perfectly replicate with delta hedging and be done.

In practice, hedging is discrete and there is a certain amount of slippage giving a random outcome with mean zero. The larger the gamma, the bigger the variance of slippage. Trading more frequently reduces the variance.

You need a non-linear pay-off to get a non-zero gamma so the underlying will not help with hedging gamma risk.

(see eg my book "more mathematical finance" for further discussion.)

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  • $\begingroup$ Thanks @Mark Joshi, I will have a look at the book. I have cecked your web page - thanks for taking part in this form as an academic and practitioner. In short: if I "have to" us BS and if I don't want to trade assets with non-linear pay-off then I do frequent Delta-hedging and this is more or less the best I can do - right? Of course I should get implied vol "right". $\endgroup$ – Ric Mar 9 '15 at 6:39
  • $\begingroup$ that is correct $\endgroup$ – Mark Joshi Mar 9 '15 at 22:46

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