If they asked the why on the exam, could you answer? (Yes, it’s in the LOS.)
Option dealer makes profit off the “dealing” not taking a speculative position on the option.
Philly… did you work on the exchange there?? If so, no credit for you!
: ) No, actually have a *friend* who works on the Phill-X floor. Actually I read this in the material somewhere; the delta hedge is used to hedge out the options, while profiting on the option dealing.
Funny how you say that… I had a *friend* who worked there too… Anyhow, full credit to you! Think it might be a good question for a quick 2-3 points or so.
Both delta hedge or keeping the same position as is will give you the same return.
How bout what are the three complicating issues with delta hedging? (for an extra bonus 2 points)
hmm… difficult to hedge when gamma is high? hedge must be continually adjusted?? rounding contracts???
- only works for small changes in the underlying 2. needs to be rebalanced frequently (as underlying changes, time passes, etc.) 3. ?
expensive?
- Delta is only an approximation 2. Delta changes over time and if the underlying changes 3. Rounding Errors
And for an extra extra bonus 3 points: 1. Explain the second-order gamma effect with delta hedging. 2. In delta-hedging a call position, which of the following pairs of conditions would lead to the gamma effect being the most important? The call is: A) at-the-money and has a long time until expiration. B) out-of-the-money and near expiration. C) at-the-money and near expiration.
The rate of change is not linear with respect to delta as the underlying changes. C
LanceTX Wrote: ------------------------------------------------------- > The rate of change is not linear with respect to > delta as the underlying changes. > > C Agree.
Right, further we move away from current price, the worse the delta approximation. Delta only accurate for small changes in underlying. For calls, delta underestimates the increase on the upside, and overestimates effects on the downside. Use gamma to measure the second order effect of the options.
to the op’s question, option dealers delta hedge becuz delta is the biggest risk on an option. whenever u go long or short an option, u have delta gamma vega thetha and some other greeks. delta is the biggest risk u can hedge out simply by buying or seling stock. gamma vega and thetha can only be hedged by “recycling” it back out another offsetting position. (e.g you sold a call, u can buy a call with a close enough strike to net out some gamma/vega exposure) option dealers incur pnl because they almost always hv some position on the greeks. they are market makers and risk takers. that’s why deriv dealers got screwed when liquidty dried up during lehman collaspe (they can’t unwind their positions/recycle risk) this is not the cfa answewr but just my knowledge on the job (i work on the derivs sales desk)
BananaCo, however most risk is actually hedged by taking offsetting positions. I don’t know anyone who only hedges the delta. Often the first thing they do is hedge the vega, then reduce the remaining delta exposure with long/short positions in the underlying. Quick fixes, however, are mostly done with just a delta hedge. Short-term positions for instance but no market maker will dare to take on all the vega exposure he will get by just delta hedging. Only delta hedging would have killed everyone last year since the volatility rose to incredible levels, they would be short a lot of vega so I doubt anyone that was just delta hedging would have made any money. 
What they normally do is not take the actual offsetting position but spread the risk around their book (they will have a big book) and often there will be mismatches in terms of maturity/strike when hedging. Especially the maturity will expose someone to risks not mentioned by CFA (I’m only doing L2 but I doubt it’s in L3): Skewrisk. The vol skew in Dec09 moves differently from Dec10 so that can cost you money as well (also profit). Anyway, since their book is normally quite big this risk is spread out but it is important to note skew risk won’t be apparent from your greeks.
Sterling76: To answer the WHY question specifically, the CFA Curriculum says: - because it is not possible to hedge by offsetting with an equal and opposite position (e.g. different number of contracts / option terms not exactly the same) AND because it is not possible to construct a synthetic hedge with put call parity
Lurky Wrote: ------------------------------------------------------- > BananaCo, however most risk is actually hedged by > taking offsetting positions. I don’t know anyone > who only hedges the delta. Often the first thing > they do is hedge the vega, then reduce the > remaining delta exposure with long/short positions > in the underlying. Quick fixes, however, are > mostly done with just a delta hedge. Short-term > positions for instance but no market maker will > dare to take on all the vega exposure he will get > by just delta hedging. > Hi Lurky - i think you missed a big part of my post 
I wrote…“gamma vega and thetha can only be hedged by “recycling” it back out another offsetting position. (e.g you sold a call, u can buy a call with a close enough strike to net out some gamma/vega exposure)”. moreoever, delta hedging does more than just eliminating/reducing/changing the direction of your delta risk. Delta hedging also allows you to realise pnl from realized volaility (from the gamma on the option). if you you are a dealer who bot a say 3m atm call from a client @ 40iv, the stock expericed an average 45iv for the next 3mths, you can realize the pnl by delta hedging it (you will hedge by buying low and selling high - imagine what you do to hedge delta on a call option where the market is oscillating up and down). retail option investors refer to this as “Gamma scapling”. and to go deeper into the subject, you only realize these profits if the stock stays rangebound close to your strike, where the most convexity on the option would be. (you lose convexity as u move deeper ITM or OTM) going back to your example tho - dealers do take on vega/gamma/theta risk - nobody perfectly hedges all their greeks. that’s why option market makers have to take a view - they make money on the bid/ask spread on market making, as well as their own views on the future volatility of the underlying - 2 sources of pnl. bid/ask spreads will be skewed towards their propensity to be long or short the various greeks of the option or otherwise. to expand on your response a little bit, the skew you are referring to is the implied volatility surface for pricing options. skew itself is a risk but it is not a greeks risk in the same vein as vega gamma theta etc. skew simply explains how you can expect option IV’s to move in relation to spot (while vega determins your option price sensitivity from the IV input). skew is commonly measured as the ratio of the IV on 90% strike options divided by the 110% strike options. as the spot moves, your option IV will experince IV shifts as explained by the skew, and term structure (which makes up the vol surface), as well as absolute vol movements as explained by market expectations. skew is not a option sensitivty - it is just the shape of the vol surface.