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Topic Title: Trading options and delta hedging
Created On Tue Mar 30, 10 06:16 AM

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ShyGuy
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Tue Mar 30, 10 06:16 AM

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I have a friend that has a very strong background in math and options. He also knows computer programming. I purchased Mathematica software. I know the basics of option pricing and derivatives. I have a basic understanding of delta hedging. Is that what market makers do, delta hedge (and neutral other greeks?)

Would it be possible to do basic option trading using my friend's math and programming background and my accounting and finance background and calculating things like the delta in Mathematica? My friend also finished the entire Hull book on options and derivatives and is amazing at derivatives? I also have a textbook that teaches Monte Carlo simulation in MS Excel, and I am sure that my friend can extend the VBA syntax to Mathematica's syntax.

Is it possible to actually generate "normal" profits (not outsized profits) using basic trading strategies such as covered calls, money and time spreads, and the like? If we figure out how to determine intrinsic value for the call and puts using option pricing theory and Mathematica as the analytical background, and we learn how to delta hedge like a pro, could we actually make supplemental income? Or are the markets already so efficient that it is not even worth trying? I don't claim to be an expert on derivatives and am a lot more knowledgeable about corporate finance, financial accounting, and valuation theory in general (not option pricing theory)?

I have the confidence to carve out a niche in event driven strategies, but my talented mathematician and engineering friends is amazing at derivatives. At this point unless I am underestimating the process it might be worth a shot for him and me to give it a try and see how we do simply for the love of trading and the learning experience if nothing else. We have all this education and now I feel we should really put it to practice.

Very interested in learning what the opinions of the forum members are.

Thanks again in advance.

rmax
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Tue Mar 30, 10 08:48 AM

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Would read Hull like your friend before parting with any cash. Delta hedging is hedging only one of many risks on an option, and it is normally done (with options) to ensure that you are exposed to the risk you want to take, and not to the risk that you do not want to take. Can you make money by buying and option and selling the delta hedge? Sure you can, you can make a truckload - however you can also lose a truckload. If you were truly neutral all greeks (and their cross-effects) you would not be exposed to any market risk, and hence you would not make any money - you would loose it all in transaction costs.

Would seriously read up a little on what you want to do, and then paper trade a little if you come up with a strategy before parting with any money. Also, where money is concerned you can never be too careful so although I am sure your friend won't try and rip you off, probably not a bad idea not to totally his judgement and do some due diligence yourself.

woohoo
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Tue Mar 30, 10 12:12 PM

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if u are really so good in the stuff - why dun u seek a job in a top bank
bring ur laptop along, show ur stuff -if u are worth the salt, u get the job. prob get paid more than what u can achieve going solo initially

Hansi
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Tue Mar 30, 10 01:03 PM

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Quote
Originally posted by: rmax
Would read Hull like your friend before parting with any cash. Delta hedging is hedging only one of many risks on an option, and it is normally done (with options) to ensure that you are exposed to the risk you want to take, and not to the risk that you do not want to take. Can you make money by buying and option and selling the delta hedge? Sure you can, you can make a truckload - however you can also lose a truckload. If you were truly neutral all greeks (and their cross-effects) you would not be exposed to any market risk, and hence you would not make any money - you would loose it all in transaction costs.

Would seriously read up a little on what you want to do, and then paper trade a little if you come up with a strategy before parting with any money. Also, where money is concerned you can never be too careful so although I am sure your friend won't try and rip you off, probably not a bad idea not to totally his judgement and do some due diligence yourself.

Got to say I admire how you handled that answer, I could easily see a number of people here flaming ShyGuy for his post.

rmax
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Tue Mar 30, 10 02:27 PM

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Quote
Originally posted by: Hansi
Quote
Originally posted by: rmax
Would read Hull like your friend before parting with any cash. Delta hedging is hedging only one of many risks on an option, and it is normally done (with options) to ensure that you are exposed to the risk you want to take, and not to the risk that you do not want to take. Can you make money by buying and option and selling the delta hedge? Sure you can, you can make a truckload - however you can also lose a truckload. If you were truly neutral all greeks (and their cross-effects) you would not be exposed to any market risk, and hence you would not make any money - you would loose it all in transaction costs.

Would seriously read up a little on what you want to do, and then paper trade a little if you come up with a strategy before parting with any money. Also, where money is concerned you can never be too careful so although I am sure your friend won't try and rip you off, probably not a bad idea not to totally his judgement and do some due diligence yourself.

Got to say I admire how you handled that answer, I could easily see a number of people here flaming ShyGuy for his post.

What would be the point to flame the guy - I was not born knowing this stuff, and I still have lots and lots to learn - many from other posts on this forum. When it comes to facts you can't flame. When it comes to opinions: its open season

MCarreira
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Tue Mar 30, 10 02:47 PM

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I've traded options at an investment bank and I've used Mathematica in analysing the delta hedging of options and strategies; a few issues:
- Using your money to trade - not the best option.
- There are many market makers out there that have significant advantages in terms of time to execution, which you probably won't have; the slippage will probably make it much worse for you.
- The advantages of volume are non-linear; trade a few options and will be exposed to some concentrated risks; trade enough options and you should be diluted enough.

Regarding your references (books), you should read Wilmott on QF, his articles on hedging with transaction costs, his article on hedging using implied or historical volatility, his articles on optimal hedging and Derman's papers (discrete hedging) and lectures on the smile; Shaw's book on Derivatives with Mathematica is very good.

Good luck !

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Martinghoul
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Tue Mar 30, 10 04:49 PM

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My answer would be that you can probably find some stuff in the world of options that would be interesting and potentially rewarding... However, it won't be easy (all the low-hanging fruit is gone) and you're going to have to overcome some serious disadvantages.

With that in mind, I would very much agree with rmax on the details. Best of luck to you and be careful out there!

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mrmister
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Wed Mar 31, 10 01:18 AM

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Option trading is a zero-sum game. You are up against people who do this for a living(and are very smart and know much more than you or your friends). Hull is a book for MBA type guys to understand about derivatives. As someone already mentioned, you can check out Wilmott on QF which is a fantastic book.

All the bookish knowledge in the world is not going to help you make consistent profits. Retail option traders usually lose all of their capital very fast. Why don't you look at strategies which are not in the zero-sum realm? How about looking at only equities and not derivatives? I am sure you can benefit quite a bit monetarily and otherwise if you have an automated trading strategy, backtest it and show that you have a decent Sharpe ratio. This might help you find some backers.

Most people lose lots of money through transactions alone. So, if you have a delta-gamma hedged strategy, you might save some transaction costs as you dont have to hedge very often. In any case, I would strongly advise anybody from entering the derivatives game.

My two cents.

daveangel
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Wed Mar 31, 10 09:01 AM

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Quote
Option trading is a zero-sum game. You are up against people who do this for a living(and are very smart and know much more than you or your friends). Hull is a book for MBA type guys to understand about derivatives. As someone already mentioned, you can check out Wilmott on QF which is a fantastic book.

whilst I agree with your sentiments I do disagree with your assertion that options trading is zero-sum. even if the market were completely between hedgers, it would by no means be zero-sum. In reality, option markets are much more heterogeneous than that - direct retail participation, indirectly through structured products, asset managers looking for protection or exposure, etc all act to create opportunities.

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ShyGuy
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Sat Apr 03, 10 02:04 AM

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Dear Wilmott Forum,

Thanks for all the replies. In all honesty, I was just thinking about option trading as a hobby to learn more about mathematics and how to use Mathematica for a pet project. I have a respectable working knowledge of financial accounting and valuation theory and have done full blown fundamental security analysis on many companies and feel very confident trying to generate alpha on long or short side of equity investments, while minimizing tracking error / active risk.

I guess my question sounded really sleezy as if I wanted to "get rich quick" doing options. Rather, I am more of the corporate finance type (i.e. modeling LBOs, M&A, IPOs, VC early stage companies, etc). I would never consider trading options as a full time profession as it is way to mathematical for my background. However, I have always had a very strong respect for quant finance (EE, CS, Math, Physics, Statistics, Financial Engineering) as just for the purposes of knowing a little bit outside my area of expertise I wanted to try to learn more about option trading and mathematical strategies. But it would only be as an intellectual exercise and for fun. Not to become a full blown stab arb trader. I leave that to the professionals trained in natural sciences.

Anyways, I feel comfortable with the replies and have learned a lot about option trading. I will read the Hull book and spend money on Mathematica training to see if somehow I can leverage the sophistication of math and software to make better investment decisions (even if it is in plain vanilla debt or equity rather than exotic options and derivatives).

Thanks,
Shayan

smarttrader
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Thu Apr 08, 10 01:19 PM

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Shayan,

Delta hedging is not suitable when you are playing with your own or client's money as the transaction costs will eventually eat your profit.
Many people take naked short postion in put / call simultaneously 15/14 days prior to expiry in order to eat the premium. So IMHO, delta hedging is more of a conceptual framework that helps you pricing....for trading if you are in a prop shop where you do not have to pay any brokerages, delta hedging makes sense as you play completely on gamma and vega.

Arghya

mrmister
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Fri Apr 09, 10 07:08 AM

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Pure delta hedging isnt done anywhere. You typically delta-gamma hedge (at a minimum). In most cases, option traders prefer to be short/long volatility depending on their view of volatility than having Greek-hedged portfolios.

RedEye
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Sat Apr 24, 10 06:02 AM

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Delta hedging is a fine tool but understand that you're not hedging to starve off risk, but rather to reproduce your initial position along the changing price spectrum. If you're short gamma you'll probably want to engage in some form of delta control as you try to receive the gamma rent of holding the position open. This is fine, but depending on your set up (assuming some sort of spread or a short straddle) delta neutrality it not the principle point of the position; it is really to sell the vols out of the market.

Naturally it's perplexing that one would want to bet on the most random variable into or resultant of BSM, however this can also be a great source of edge. Consider, for the NASDAQ 100, ATM volatility is currently the lowest in several seasons, and a 30 day out ATM straddle should sell for 60-70. In OCT 08, with only 6 days left to expiration, the same ATM straddle traded for over 150 and if I remember correctly over 160 at one point. Just an example but it shows how dynamic the pricing is according to the expectations of the market.
When you get to extreme moves such as OCT 08 traders with simple textbook positions will actually forgo any sort of delta hedge and simply take their position off and relocate it over the ATMs which are now in play. This is because they understand the point of their exercise and that is to keep the rent rolling, and instead of trying to shave or lean deltas which can just pitch money away in a bad headwind, they'll just move into the neighborhood with the best rent.

closdubois
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Tue Apr 27, 10 06:39 AM

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"delta hedge like a pro"
lol..

if you're trading options, hedging stock has nothing to do w/ making money

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