3
$\begingroup$

Say, for instance, that you've set up a delta-neutral straddle (i.e. you are long volatility, short time decay) and want to dynamically hedge your gamma in order to offset losses due to theta. Is there a commonly used framework that compares the cost of rebalancing the hedge against the growing theta exposure?

I recall reading that a 1 s.d. move represents the break even point between gamma and theta, so that or a slightly larger move that would cover both theoretical loss due to time decay and the real, fixed execution cost associated with rebalancing seems like a reasonable place to start, but I'm not sure why that would be the only place to do it.

Improve this question
$\endgroup$
1
$\begingroup$

Commonly used procedures are to hedge;

  1. when a 1 SD move has happened, or
  2. when your delta position exceeds some risk limit, or
  3. once a day, or
  4. based on your desired delta position.

All are used. I personally prefer (2).

Improve this answer
$\endgroup$
3
  • $\begingroup$ Thanks for these - do you know if anyone tries to factor in the execution cost of hedging? Will write up a second question asking more about how risk limits are derived in practice $\endgroup$ – Andrew Maliska Apr 19 '16 at 19:42
  • $\begingroup$ My experience is in liquid markets where bid/offers are quite small, so doesn't impact the decision much. If bid-offers were wide you would transact less often than otherwise , that's true. $\endgroup$ – dm63 Apr 21 '16 at 2:17
  • $\begingroup$ This [paper][1] on "Empirical properties of straddle returns" has an interesting analysis of the profitability of straddles under different rebalancing frequencies. [1]: risk.edhec.edu/sites/risk/files/… $\endgroup$ – John Apr 23 '20 at 17:04

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.