Saturday, October 10, 2009

Mail Time- Delta Hedging

I received a question in response to my Playing with Semis and The Trade off: Risk-Reward vs. Probability of Profit posts. I would have just answered in the comment section but either due to my technological ignorance or Bloggers weak sauce program, I'm not sure how to enter hyperlinks or edit other text within the comments section.

Speaking of the comments section.... some of you may not be aware that at the end of every post, there is indeed a comment section where you can post thoughts, questions, disagreements, or random musings.

On to the questions at hand (in blue):

Greetings Tyler:

...if you have more discussion of delta hedging, please point me to it...

Besides my prior posts on Delta, I have yet to do a solid series of posts on delta hedging. One of these days I'll get around to it. A few weeks back Condor Options had a well written post titled: The Lazy Guide to Delta Hedging. It's worth a read when you get the time. Also, Sheldon Natenberg's book Option Volatility and Pricing contains some solid information on delta hedging as well.

A couple follow up questions:

If you exit (vertical spreads) when you achieve 80% of credit, does this number factor into the spread selection? Since you put this (the bear call spread on SMH) on for 15% max ROI but will really get more like 12% if you exit at 80% credit collected. Which ROI are you looking at when you put it on?

Usually I'm looking at the 15%. Although I'm almost always exiting prior to expiration without achieving the entire potential profit, the last few percent aren't a big deal IMO.

A few more on delta hedging. What do you mean by "daily resistance"? Resistance on the daily chart or intraday resistance?

To me daily resistance = resistance on the daily chart. Weekly resistance = resistance on the weekly chart. 5 min. resistance = resistance on the 5 minute chart. etc...

If you delta hedge - I am assuming that you are using the underlying here. When do you take the hedge off? Do you have a stop out for the hedge? Do you leave it on overnight?

In the case of a call spread on SMH, yeah I would use the underlying stock to hedge (if I decide to hedge the position). The timing for hedging a directional trade is subjective and depends on the trader IMO. The general idea would be to hedge when the position is moving adversely (up in this case). Then take the hedge off when the stock is moving the right way (down). Rather than hedging at random, one could use technical analysis in an attempt to have more precise, rationale entries/exits on the hedge. If SMH stays neutral to bearish, then no need to hedge. It's doing what we want it to do. If SMH started to get more bullish, one may consider delta hedging by buying shares of stock. Generally breaking resistance is what changes my personal outlook on a stock, so I may use a break of resistance as my trigger for when to hedge.

I do have a stop for the hedge (long stock in this case). Last thing I want to do is lose more money on the hedge than what I realize in the original trade. At some point I've got to exit the hedge if SMH starts going back down in price. You could potentially use a daily low as your stop.

I do leave it on overnight if needed. I would hate to have to re-establish a hedge EVERY single day and rack up commission costs.

Finally, why would you exit vs. delta hedge? Is this just based on a max loss on the initial spread being hit?

Keep in mind that delta hedging is a complex subject and it's very hard to give one specific answer to any question. The majority of the time there isn't one "right" answer. Deciding when to hedge, how to hedge, whether to hedge or exit, etc... comes down to personal preference, risk tolerance, and the type of position. Hedging a position meant to be delta neutral, such as a condor or strangle, is much different than hedging a directional trade, such as a long call or vertical spreads.

On to the question. I usually choose to exit directional trades rather than hedging. Delta hedging is quite complex and for most traders they would be better off just closing the original position if it moves adversely. Think about all the additional questions that you need to consider when hedging:

When do I delta hedge?
What should I use to delta hedge?
How much do I hedge?
When do I take off the hedge?
When do I put it back on?
When do I increase or decrease the hedge?
If I delta hedge and the position continues to move against me, when do I just scrap the trade instead of continuing to hedge?

Some traders would rather say, "OK, I was wrong. I'm simply getting out to minimize the loss." Rather than delta hedging and trying to tackle all the aforementioned questions. Delta hedging requires a lot more active management than some people want to put in.

I've got another question regarding naked strangles vs. iron condors that I'll tackle next week.

3 comments:

semuren said...

Thanks Tyler for your answers. I think your method of hedging then seems to fit into "#2 Price Based" hedging in the typology that Jared gave in the Lazy Guide post. Now, if I hedge I use Jared's method #3 Fixed Delta Bands, but I think this seems to be less than optimal. But so far something along the lines of Jared's #4 Variable Delta bands, while it seems desirable (to try and account for changes in gamma and IV) is beyond my grasp. The equations in the Zakamouline article he cites make my eyes glaze over. I hope the information in the Sinclair book proves to be more accessible. I will look back over Natenberg too.

Thanks and good luck with the trade.

Mark Wolfinger said...

Tyler,

I'd like to take a stab at this one:

"Finally, why would you exit vs. delta hedge? Is this just based on a max loss on the initial spread being hit?"

1) Hedging involves more than getting delta neutral. Gamma is also of major concern. Hedging with stock get you ZERO gamma.

2) Some positions are just bad. Their prospects of earning a profit (from the current time) are remote. Of course if you want to hold a bad position and HOPE that the stock reverses direction, you can do that. But hoping is not a realistic strategy.

If your position is in this category - or is getting there - why hedge? Why try to turn a bad position profitable? Exit.

Take the loss and invest your money into a new position - one that is much more likely to be profitable.

3) Exiting is an underutilized hedging strategy. Nothing gets you more neutral than closing the trade.

4) You 'maximum loss being hit' doesn't apply once you hedged. I would ignore that aspect.

5) Bottom line: If you go ahead and hedge the position - will the new position be one you TRULY WANT TO OWN?

If yes, hedge.

If no, exit. Don't hold garbage in an attempt to recover the loss

Mark
http://blog.mdwoptions.com

Tyler Craig said...

Mark-

Great stab. Definately some legit points worth considering. I would agree that once a trader learns of adjusting positions or delta hedging, they probably over utilize it in an attempt to 'fix' every bad position. I know when I was first introduced to the idea, I probably used it one too many times. I think after enough experimenting with hedging, you start to see the benefits of just exiting certain trades and finding greener pastures.