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)?