What is Delta Hedging || Dynamic Delta Hedging like a Quant || Profit & Loss Options Trading

Summary

In this video, Jonathan discusses the profitability of market makers and quants when dynamically hedging option positions. He explains delta hedging, a method to hedge directional risk by transacting in the underlying asset. The video explores dynamic versus static hedging strategies and their impact on option pricing, emphasizing the importance of realized volatility. Using Commonwealth Bank of Australia as an example, Jonathan walks through various hedging scenarios and their outcomes, showing how volatility plays a key role in profitability. He concludes by encouraging viewers to follow his upcoming volatility challenge.

Takeaways

• 📊 Delta hedging is a strategy used by market makers and quants to dynamically hedge option positions by transacting in both the underlying asset and bank account to manage directional risk.
• ⚖️ The core of option pricing is portfolio replication, where traders constantly adjust their position in the underlying asset to hedge risk.
• 📉 Delta is calculated for options positions, and adjustments are made depending on whether the trader is long or short in their options position. For longs, buying occurs at low prices and selling at high prices, and the reverse applies for shorts.
• 💡 Realized volatility is a crucial factor for option traders, as it significantly impacts the profitability of options trades. Incorrect predictions of realized volatility can lead to either large gains or losses.
• 🏦 Example used: Commonwealth Bank of Australia options at $202 strike price for November 18 expiry, with market makers showing differing implied volatilities for call and put options.
• 📈 The market maker sets implied volatility based on supply and demand dynamics. For the CBA example, calls have lower implied volatility (around 12-16%) while puts have higher implied volatility (26-29%).
• 🔄 Dynamic delta hedging involves regularly adjusting the delta hedge over time as the price of the underlying asset fluctuates. Traders aim to converge on the theoretical option price by managing these adjustments.
• 💰 Performance of option trades depends on realized volatility. Traders who buy high implied volatility and see low realized volatility will lose money, while those who buy low and realize high will profit.
• 📉 Hedging strategies vary: dynamic hedging leads to more consistent but narrower profit distributions, while static or no hedging can result in larger upside but also significantly larger potential downside risks.
• 📊 The video concludes by highlighting the importance of forecasting realized volatility to improve trading outcomes and offering a future challenge related to realized volatility forecasting.

Q & A

What is delta hedging in options trading?

Delta hedging is a strategy where a trader transacts in both the underlying asset and the bank account to hedge directional risk when holding options. By dynamically adjusting the position in the underlying asset based on the option's delta, the trader seeks to minimize directional exposure and reduce risk.

How does delta hedging work for long and short options positions?

For long options positions, delta hedging involves buying the underlying asset when prices are low and selling when prices are high. For short options positions, the strategy is reversed, where the trader buys when prices rise and sells when prices fall. This helps reduce directional risk over time.

What is the importance of realized volatility in options trading?

Realized volatility is crucial for options traders because it impacts the profitability of their hedging strategies. If realized volatility is lower than expected, a trader who bought options at a high implied volatility may lose money. Conversely, if realized volatility exceeds the implied volatility at purchase, the trader can profit.

What is the difference between dynamic delta hedging and static delta hedging?

Dynamic delta hedging involves continuously adjusting the hedge position throughout the life of the option based on price changes, while static delta hedging involves adjusting the hedge only once, usually at the time of entering the position. Dynamic hedging seeks to closely track the theoretical pricing, while static hedging may result in larger profit and loss variations.

Why do market makers demand different implied volatilities for call and put options?

Market makers demand different implied volatilities for calls and puts due to supply and demand in the market. In the provided example, higher demand for put options led to a higher implied volatility (around 29%) compared to calls, which had lower implied volatility (12-16%) due to lower demand.

How is the premium for an option calculated and used in delta hedging?

The premium for an option is calculated based on its bid price, which reflects what the market maker is willing to pay. In delta hedging, the premium is received upfront and interest can be earned on it. The premium also affects the overall P&L calculations when the option position is closed.

What role does interest play in dynamic delta hedging?

Interest is earned on the premium received when entering an option position and must be considered in P&L calculations. Additionally, traders may borrow money to buy the underlying asset for hedging, and the interest paid on that borrowed amount also impacts the overall returns.

What happens if realized volatility is lower than implied volatility in options trading?

If realized volatility is lower than the implied volatility at which the option was bought, the trader will lose money. This is because the price paid for the option was based on an expectation of higher volatility, which did not materialize, leading to a mismatch in pricing.

How do dynamic and static delta hedging strategies compare in terms of risk and reward?

Dynamic delta hedging tends to result in tighter, more consistent outcomes with lower downside risk, but it may also limit upside potential. Static delta hedging, while offering higher potential upside, exposes traders to greater downside risk, as fewer adjustments are made throughout the option’s life.

What is the significance of modeling multiple scenarios in options trading?

Modeling multiple scenarios, such as through 1,000 simulations, helps traders understand the range of possible outcomes for different hedging strategies. It shows how profits and losses can vary under different conditions, like changing levels of realized volatility, and helps traders choose strategies that align with their risk tolerance.