Ericsson's Massive Intradya Gap and the Failure of BSM Delta Hedging

Yesterdays massive intraday gap in Ericsson (25%) was just a good reminder on how the idea of continuous time delta hedging to remove all the risk all the time to argue for risk-neutral valuation is not even a good approximation, it is simply flawed for any practical purpose. And in particular when you really need to remove risk.

If you had been selling otm options and delta hedging them before the massive intraday gap you would got rid of a minimal amount of risk, if this was a large part of your position you would have been blowing up.

Knowledgeable option traders have known this for a long time pre-dating Black-Scholes and Merton, they use much more robust hedging techniques, at least truncating their tail exposure (options against options).

Stochastic volatility models if they relay on delta hedging to remove most risk will unfortunately not help much in cases like this. Yes the SV model will fit the volatility smile and possibly give slightly higher delta for your otm options. When the market gap like this you will even be fried with your SV model (if you not have taken the appropriate steps described in chapter 2 Models on Models ;-). Knowledgeable option traders using options against option hedges will do fine!

Delta hedging removes quite some risk in many cases, and discrete delta hedging was known before Black-Scholes-Merton. But non of these partly ignored practical researchers ever claimed delta hedging could be used as argument for risk neutral valuation.

I am sure some market maker or option trader that actually believed in the delta hedging argument to remove almost all risk got fried in the Ericsson gap. Some long options naturally made a lot of money, staying long options did not make delta hedging work any better, but the risk from its large hedging errors are not symmetric (but did not necessary give you edge). Black-Scholes-Merton did nothing wrong, they pointed out some theoretical academic idea, with nice mathematical result (that not was close hold in practice). That so many believed in their argument was the mistake that potentially have slowed the evolution of quantitative finance, and cost many naiive traders coming out from business school (often brain washed) millions of dollars, or at least for their employer. Well in derivatives ones loss is often anothers gain ;-)