Delta hedge and option insurance

CFA Level III
#1

In one of the Schweser exam practise question, it mentions delta hedging with option “will more closely hedge the exposure than option insurance strategy”

I don’t understand, can anyone help?

Thanks!

#2

they are comparing delta hedging to buying put options. if you buy put options, you protect your portfolio value from fall below some absolute level. delta hedging tries to neutralize the change in the portfolio value. a delta hedge has a hedge effectiveness ratio much closer to using a simple forward, and is far more effective than put options at hedging the underlying for small price changes.

#3

delta hedge was what?try to hedge your exposure in stock by buying options right? it shows the change in option price for a unit change in underlying asset…If asset changes 1 as oprtion price changes 0,5, you have to buy 2 options…,

#4

normally when you think of options , you think :

I need insurance against big damage … or

I can give up some upside to buy safety but want a substantial gain

So these are insurance strategies.

You take the same options and delta-hedge , you are literally neutralizing damage but agree to give up all upside. delta-hedging is hedging , no gain and no loss either

#5

I agree with 1BigStudMuffin. The delta hedge “more closely hedges” because it is continuosly rebalanced and therefore tracks the risk of continual market movements. The option insurance strategy is a one time transaction and as time goes by the chances of the position requiring different treatment increases and therefore becomes less “close”.

#6

thank you for all the response.

sandy, can you provide one example of how the option become less “close”?

suppose the current spot price is $50, and in order to hedge the adverse price movement, i could buy a $50 put. when the spot price drop to, say, $48, i could exercise my put and earn $2. (and incur the expense of option premium). In this sense, why bother to use delta hedge, given its need to rebalance frequently and incur a lot of transaction cost? And how it better hedges than option insurance? Thank you!

#7

The delta hedging is not to make profits (theoretically). In practice, delta hedging can capture changes in volatility assumptions, so that you can make small gains at expiry or when vol changes. you have to do it many times and need tons of capital to make it worth it. It’s what option market makers do.