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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.

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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).

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  • $\begingroup$ 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

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