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I dont understand how MM protect themselves from large moves in underlying while being delta hedged.

Example:
MM sels 1 ATM put and sells 100stock (delta = 1) as a hedge. Now what will happen if next day stock shoots up? I can't imagine MM losing money on every such occasion, but I don't get how can they protect from it?

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  • $\begingroup$ Assuming a (clearly utopic) scenario where you have also perfectly hedged your Gamma this is not a problem (because both the option and the stocks become linear functions of the spot in that case, there is no convexity). Of course hedging Gamma requires to trade other options. This example just shows why MM tend to manage their books from a macroscopic perspective, i.e. look at Greeks and try to keep them all flat on a global level. This is not as easy as it may seem though. $\endgroup$ – Quantuple Jun 1 '16 at 13:01
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That's the risk that MM's take, generally. This is commonly referred to as "gap risk". Holistically the idea is that with the law of large numbers you will lose sometimes but overall be OK as you have a large number of these trades.

On our MM desk we have seen a few times where big takeovers were preceded by someone in the market lifting 10k call contracts on all strikes of the acquiring name. Stinks when it happens but hopefully you make it back in a thousand other places.

You've heard that expression, "picking up nickels in front of a steamroller" ?

For the book as a whole the MM tries to keep all the greeks reasonably flat.

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  • $\begingroup$ Thank you Josh, the phrase "picking up nickels in front of a steamroller" is exactly why I asked this question. $\endgroup$ – Yuriy Jun 1 '16 at 13:28
  • $\begingroup$ My pleasure. Options MM is a tough business. $\endgroup$ – JoshK Jun 1 '16 at 13:41

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